Warning Of Slower Growth And High Inflation Puts Investors In A Spin

Sydney Morning Herald

Tuesday February 12, 2008

Jacob Saulwick

THE Reserve Bank has predicted economic growth will slow considerably this year, but not by enough to halt the upward march of interest rates.

The bank's hawkish statement, tipping a long period of high inflation even as the economy lost power in the months ahead, shocked investors. It sent the sharemarket diving and money markets into a spin by flashing a clear signal interest rates would rise further in the coming months.

The bank expects inflation to outstrip its mandated maximum of 3 per cent until at least 2010.

"Absent a further shift in economic risks to the downside ... monetary policy is likely to need to be tighter in the period ahead," it said in its quarterly Statement on Monetary Policy, released yesterday.

The interest rate rises will come on top of a 60 per cent fall in the rate of growth in the non-farm economy, according to the bank's predictions.

Stripping out the drought-affected agricultural sector, the economy grew by 4.5 per cent in the year to September. But the non-farm growth rate could slow to 2.75 per cent this year, the bank predicted. In the same period, inflation is poised to hit 3.75 per cent.

Investors carved more than 2 per cent off the sharemarket in response to the new forecasts. The ASX200 closed 120.4 points, or 2.13 per cent, lower at 5537.6, while the All Ordinaries lost 120.8 points, or 2.11 per cent, to 5603.1.

Government bond yields soared and the currency leapt above US90c on the heightened expectation of a rate rise next month. The yield on the September 2009 bond rose 0.10 points to 6.79 per cent, while the dollar finished US0.83c higher at US90.31c.

The chief economist at ABN Amro, Kieran Davies, said the combination pointed to an "unpleasant mix" of slower growth and high inflation.

"This tells you the housing market and retail sectors are going to come under a lot of pressure and the broader economy will feel it through a rising unemployment rate," Mr Davies said.

He said earnings forecasts for companies would have to be lowered if inflation remained insensitive to higher interest rates, forcing the Reserve Bank to keep lifting them. He said any rise in joblessness would hit the economy hard, given the large amount of debt many people are in.

The statement said inflation was affected by two opposing forces: a strong domestic economy pushed inflation up, but a worsening global outlook was likely to take some of the heat out of the domestic economy.

In the wash-up of the US mortgage meltdown, economies with strong links to Australia are expected to slow.

The bank predicted growth in Australia's major trading partners would slow from about 5 per cent in 2007 to about 3.75 per cent this year.

But, at this stage, the Reserve Bank considers the international jitters are unlikely to reduce demand in the economy to the point where inflation starts to ease.

Part of the problem is that increases in coal and iron ore prices are expected to give the domestic economy a boost and ensure the terms of trade - the ratio of export prices to import prices - climb to new highs.

Recent rain was also expected to revive the agricultural sector.