Rates On Hold As Rba Says It Has Cooled Economy

The Age

Wednesday July 2, 2008

Scott Murdoch

THE prospect of a fresh interest rate rise for the Australian economy is off the Reserve Bank's agenda, after it emphasised its strategy of tackling inflation by cooling the economy was working.

The decision by the central bank yesterday to leave the official cash rate at 7.25% was expected by the financial markets, but the tone of the statement by governor Glenn Stevens was more dovish and put the RBA into a neutral phase for monetary policy.

He said the RBA realised the effect that the high price of oil was having on the Australian economy, but admitted it was a key driver of the current global inflationary pressures.

The statement highlighted that the bank expected the fourth-quarter inflation result, published on July 23, would be high. However, it predicted the slowdown in economic activity would moderate inflation in the medium term.

"The evidence is that the tightening in financial conditions, in conjunction with other factors including rising fuel costs, is working to restrain demand," Mr Stevens said.

"Indicators of household spending have recorded subdued outcomes over recent months and credit expansion to both household and businesses have weakened significantly.

"There have also been some signs of an easing in labour market conditions."

Economists said the Stevens statement was a significant shift for the RBA's interest rate stance into neutral territory after the previous tightening bias.

The change in outlook prompted futures markets traders to sell down the likelihood of the Reserve Bank taking action before the end of the year.

The chance of an August rate hike is now down to 16%, October was sold off from 36% to 28% and December's odds moved from 68% to 52% on the interbank futures markets.

The rates news was coupled with soft economic data which showed business investment would weaken further because of the mixed outlook and a 5% drop in new home sales.

ANZ's co-head of economics, Sally Auld, said the market had been positioned for the RBA to keep its tightening bias against the backdrop of high global inflation.

"I think the market was surprised by how dovish it was," she said.

"There was almost a mixed message on petrol prices. The bank said petrol prices were dampening demand but then on the other hand that oil was a risk to global inflation."

The Australian dollar came under renewed pressure on the rates outlook after the domestic currency reached a fresh high of US96.36 in New York trade. The $A was sold down in the local session to US95.50.

The RBA's outlook came after the startling warning from the Bank for International Settlements (BIS) that the stability of the global financial system was at risk, given the ongoing fallout from the credit crunch.

In a veiled attack on the Federal Reserve's management of the subprime crisis, it said lower interest rates were not the best solution to reviving the global economy.

The Australian equities market began the new financial year on a sour note, as investors wiped another 1.35% from the benchmark index, the S&P/ ASX200.

Treasurer Wayne Swan said that, while the Australian economy had been mostly shielded by the subprime fallout and the US economic slowdown, the financial markets were exposed to global volatility.

The Australian equities market finished the year as the eighth worst performing market in the world. "Well there's no doubt that there has been substantial problems in international financial markets following directly from what's occurred in the United States and spreading out to the rest of the world. That's what's caused the problems on share markets around the world, the impact on confidence and so on," Mr Swan said.

MONETARY POLICY STATEMENT BY RBA GOVERNOR GLENN STEVENS

At its meeting today, the board decided to leave the cash rate unchanged at 7.25%.

Inflation in Australia has been high over the past year in an environment of limited spare capacity and earlier strong growth in demand. In these circumstances, the board has been seeking to restrain demand in order to reduce inflation over time .

As a result of earlier decisions by the board, additional rises in market interest rates and tougher credit standards for some borrowers, there has been a substantial tightening in financial conditions since the middle of last year . Conditions in international financial markets remain difficult, with credit concerns resurfacing in the past month .

The evidence is that the tightening in financial conditions, in conjunction with other factors including rising fuel costs, is working to restrain demand. Indicators of household spending have recorded subdued outcomes over recent months, and credit expansion to both households and businesses has weakened significantly . There have also been some tentative signs of an easing in labour market conditions.

The rise in Australia's terms of trade that is currently occurring will work in the opposite direction. It will add substantially to national income and ability to spend, even with the slowing in global growth to below-trend pace that the Bank is assuming. At the same time, rising prices of oil and a range of other commodities are adding to global inflationary risks .

Given the opposing forces at work, considerable uncertainty remains about the outlook for demand and inflation. On balance, while the inflation outlook remains concerning, the Board's assessment continues to be that demand growth will be moderate this year .

The most recent flow of information has given additional support to that assessment. Inflation is likely to remain relatively high in the short term, and the CPI will be further boosted in coming quarters by the recent rises in global oil prices . Looking further ahead, inflation in both CPI and underlying terms should decline over time, provided demand continues to evolve as expected.

Weighing up the available domestic and international information, the Board's judgement is that the current stance of monetary policy remains appropriate 8 . The Board will continue to evaluate prospects for economic activity and inflation in the light of new information.

ANNOTATIONS BY SCOTT MURDOCH, ECONOMICS COMMENTATOR

1 The Reserve Bank has been banking on a dedicated strategy of tackling inflation, by cooling the economy after six years and 12 interest rate rises.

2 If the RBA's policy tightenings weren't enough, the retail banks followed through with four rounds of hikes independent of the RBA. The non-bank lenders have hiked rates more than their traditional counterparts as well. Since July last year, lending rates are up to 140 basis points higher.

3 Credit spreads have started to widen again, particularly amid concerns there could be further write-downs from the US investment banks. The spreads between Australian corporate and government bonds have moved wider as have the spreads on the three-month Libor to overnight swaps have moved wider.

4 Demand for credit is down while petrol is now one of the biggest costs to consumers' budgets. The average household now spends $227 a month on fuel, up $40 over the past few months.

5 The RBA faces a precarious task with most of the economy moderating after all of the interest rate rises. However, the resource rich states are powering ahead and mining companies are not hit by rate rises. Rio Tinto this week secured an average 90% increase in iron ore contract prices with its Asian buyers.

6 The Australian economy is slowing but the data is yet to show whether the moderation is occurring at a pace welcomed by the RBA. The last GDP number showed growth was 3.6% for the year.

7 The fourth-quarter CPI number published on July 23 could be a shocker because of the sky-high price of oil. ANZ Bank has forecast 1.3% core inflation result for the quarter, which takes the annual rate to 4.6% - well above the 2-3% management bracket.

8 Interest rates are finally working for the first time in six years.

The economy is starting to slow and probably by more than the data reveals. The RBA is likely to be on hold at least until the end of the year.