The Reserve Bank's Statement on Monetary Policy (SoMP) has printed a set of forecasts that indicate that it is very close to raising interest rates.
Westpac has consistently argued that the next move will be in the September quarter, but a move in June has now become the more likely result.
In assessing the RBA’s intentions, the key indicators are its forecasts and the choice of words in the final paragraph of the introduction which assesses the policy stance.
In this week’s final paragraph the following words are used: "The central outlook selected above suggests that further tightening of monetary policy is likely to be required at some point for inflation to remain consistent with the 2-3% medium-term target."
Compare this with the RBA’s statement in October 2010: "If economic conditions evolve as the Board currently expects, it is likely that higher interest rates will be required, at some point, to ensure that inflation remains consistent with the medium-term target." Recall that the Bank tightened at the following Board meeting in November.
The forecast for underlying inflation in 2011 has been increased from 2.75% to 3%; has been retained at 3% for 2012; but for the first time a forecast for 2013 has been printed and that number is 3.25%.
Bear in mind that these forecasts are predicated on current market pricing for interest rates which up until now has only anticipated one rate hike by the middle of next year. In indicating that on the basis of current market pricing the Bank is likely to exceed its 2-3% target range it is reasonable to conclude that the Bank is sending a clear message that market pricing is too benign.
We also interpret the choice of 3% in 2011 as being equally hawkish and indicating that there is basically no room for slippage on the inflation target.
Partly driving these hawkish inflation forecasts is a much more optimistic outlook for economic growth than we saw in the February SoMP and certainly more than we expect at Westpac. Growth in 2011 is forecast to be 4.25%. We know from the Governor's statement on Tuesday that the Bank expects the economy to contract in the March quarter mainly because of disruptions to coal and iron ore exports.
While we expect a contraction of 1% of GDP in the March quarter it is likely that the Bank is expecting –0.5%. Based on the six month profile provided in the forecasts, we estimate the Bank is assuming 1.6% growth in the first half of the year and 2.6% growth in the second half. That implies 2.1% growth in the second quarter and the final two quarters averaging 1.3%. That compares with Westpac’s own forecasts of 1.5% in the second quarter and 2.2% over the second half of the year (on the assumption of a September quarter rate hike).
There has also been an improved forecast for the labour market. In February, the unemployment rate was forecast to reach 4.5% by mid-2013. It is now forecast to reach 4.25% by end of 2013.
The discussion on the risks to the forecasts has once again referred to the household sector as a potential upside risk. The forecasts are based around the current high savings rate being unchanged whereas the risk is now seen that with tightening labour markets and rising wages households may become more confident.
Recall that in the February statement the cautious consumer was seen to be a downside risk, while in the November statement the consumer was seen to be an upside risk. One risk that is consistently seen to be an upside risk to growth and inflation and dominates this statement is that the pick-up in mining investment continues with aggressive competition for labour leading to more pressure on wages. We find the comparison with the resources boom in 2006-2008 curious given the very different consumer/housing environment that existed at the time.
The impact of the exchange rate on the economy is recognised and incorporated in the forecasts, although this development is seen as an "uncertainty" rather than a specific upside or downside risk.
Growth in the world economy is still forecast to be above trend and commodity markets assumed to remain tight. Risks around policy responses are both to the upside and the downside with the emphasis being that policy in Asia may well be too slow to respond to tightening needs giving the Australian economy a stronger boost in the near term.
The change in the forecasts and the choice of words in the key paragraphs indicate to Westpac that the RBA is likely to raise rates at it’s next meeting in June. This represents a slight pull-forward in Westpac’s long-held view that rates would be increased in the September quarter.
However it does not change our view that this move will be a one-off in 2011. It is true that the Bank's forecasts as they stand in this statement are consistent with a sequence of rate hikes over the remainder of the year and into 2012. However, we disagree with the strength of the growth outlook and certainly expect a stronger response from the household sector to this next rate hike than is implied in the Bank's forecasts.
It will have been seven months since the Bank last tightened, which was at a time of a much lower currency and a healthier housing market and more positive consumer. As rates move further into the contractionary zone, the decision to hike becomes more difficult, especially when large sectors of the economy are already experiencing difficulties.
Westpac retains its view that the next rate hike following this expected decision in June will be delayed until the June quarter next year.