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2011's cash rate outlook

Glenn Baker
8 December 2010

After having surprised the market last month, the Reserve Bank delivered a predicted result by leaving the official cash rate unchanged at 4.75 per cent following the December Board meeting.

There have been a considerable number of factors that changed in the economic and market environment over the course of the last month and taken together these changes contributed to a stable outcome for the balance of 2010. Furthermore, it is now highly likely that the Reserve Bank will maintain a stable cash rate for some months to come, potentially well into 2011.

The following summarises the key changes observed.

  • Banks added to the impact of the November official interest rate rise by further increasing the rates charged to borrowers due to the need to pass on increased funding costs.
  • Retail sales for October showed a decline.
  • Credit growth remained subdued.
  • The unemployment rate reported for the month of October rose to 5.4 per cent from 5.1 per cent.
  • Australia's third quarter economic growth rate slowed considerably relative to growth rates evidenced in the first half of 2010.
  • Concerns re-emerged in relation to the debt levels and fiscal position of a number of European countries and the stability of their banking systems, particularly Ireland which was ultimately provided with a rescue package by the European Union and the International Monetary Fund.
  • These latter events in Europe further unsettled global financial markets.
  • All these factors followed on from the third quarter inflation data that showed that inflation at that time was continuing to fall and had settled at the bottom half of the Reserve Bank target range, albeit that the Reserve Bank was forecasting inflation to rise to a higher level over time.

In the days leading up to the latest Board meeting the Governor, Glenn Stevens acknowledged that the climate since the last meeting rate increase had shifted particularly given the additional rate changes added by banks and that lending rates, which the Reserve Bank is more focused on now, were at an appropriate level, being a little above average, and that policy may not need to be adjusted for some months. This gave a significant signal that there would be a 'no change' decision at the December meeting or indeed potentially for some months. Caution does need to be exercised, however, as a statement at a point in time will not necessarily hold for very long if the data moves in a manner to negate that view.

So, while there is considerable comfort in the immediate future that the official cash rate will not move again, there is still a longer-term view that there is potential for higher inflation to develop and that action will need to be taken to arrest this via tighter monetary policy. Australia is the beneficiary of record commodity prices and extremely favourable terms of trade. This is boosting national income through very strong export performance, driven in the main by strong demand from China for our iron ore and coal in particular.

The labour market is very strong despite the recent increase in the unemployment rate which was driven by a rise in the participation rate as more people joined the search for work. Investment, especially in mining and related areas is significant and it is highly likely that as the economy expands on the back of the mining boom pressure will be brought to bear on a tightening labour market that will ultimately translate into higher wages and a more general push on prices. The Reserve Bank's current outlook for inflation is that it will be little changed over the next few quarters before it increases over the medium term as the economy expands.

There has been evidence of a 'two-speed' economy with the commodity driven sectors such as mining being super-strong and interest rate sensitive sectors such as retail spending and housing being under pressure from a series of interest rate increases that have negatively impacted consumer confidence and reduced the capacity of households to spend. Monetary policy cannot be applied in a differential manner to slow one sector whilst leaving others to improve their growth.

The Reserve Bank has a difficult task at present in balancing the short term actual performance of the economy and inflation against the longer term potential outcome. In this situation, it is anticipated that a reasonable pause in the application of tighter policy will breathe some life back into the weaker sectors before there is a need to apply the brakes again to avoid overheating in the totality of the economy, led by the booming mining and export activity. Expect no rate change until well into 2011, probably May at the earliest but then for there to be rate increases of up to 0.5 per cent over the balance of 2011 to take the official cash rate to 5.25 per cent by the end of that year.

Important information: This content has been prepared without taking account of the objectives, financial situation or needs of any particular individual. It does not constitute formal advice. For this reason, any individual should, before acting, consider the appropriateness of the information, having regard to the individual’s objectives, financial situation and needs and, if necessary, seek appropriate professional advice.

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