RBA threatens big stick

Increased interest rates are definitely on the cards if inflation doesn't slow down.

Whilst the Reserve Bank has left the cash rate unchanged at 7.25%, it also warned that rates would rise if inflation didn't calm down and wage rises were allowed to get out of control.

The warning, delivered in an accompanying explanatory statement from Governor, Glenn Stevens, follows the surprisingly strong 4.2% rise in the March quarter's Consumer Price Index, which was very close to the bank's own favoured measures of around 4.1%.

The bank signalled its changed stance but reverting to the language of February and March, after the rate rises, by warning that it will pick up the big stick and whack the economy again if inflation doesn't slow.

In view of that change, the Minutes for yesterday's meeting will make interesting reading when released on May 20. They could show that a rate rise was entertained during yesterday's discussions, a bit like the way the board minutes for the February meeting revealed a flirtation with a 0.50% lift in the cash rate to surprise the market completely.

The Reserve Bank has raised borrowing costs 12 times since May 2002, when the rate was 4.25%. The US Fed has cut rates seven times since last September to a 2% Federal Funds Rate last week. The Bank of England has cut rates twice this year to 5%, the Bank of Canada has also cut rates and the Bank of Japan is no longer talking about a possible rate rise in its 2008 outlook, released last week.
The European Central bank has not budged from its rate of 4% as business conditions become sluggish and inflation rises, thanks to higher food and oil costs. The ECB and the BoE meet Thursday night.

So in some respects the RBA reflects the state of the Australian economy.

Thanks to the resources boom it remains a strong economy, but domestic demand is being deliberately slowed to take the weight off demand pressures. Although retail sales are more subdued than for most of 2007, building approvals are down, as is consumer confidence, the RBA wants to see more, and this could be provided in the April labour force figures which will be another important indicator. A rise to say 4.4% would be another sign that domestic conditions are easing. And on Friday the RBA releases its second Monetary Policy Statement of the year with new inflation forecasts.

They are likely to amplify this comment from the statement by Governor, Glenn Stevens:

"Given the opposing forces at work, considerable uncertainty remains about the outlook for demand and inflation. On balance, the Board's current assessment is that demand growth will remain moderate this year.
In the short term, inflation is likely to remain relatively high, but it should decline over time provided demand evolves as expected.
Should demand not slow as expected or should expectations of high ongoing inflation begin to affect wage and price setting, that outlook would need to be reviewed.

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

After the announcement the Australian dollar shed about one third of a US cent after the announcement, reflecting the view that further rate rises are unlikely for now. The Aussie dollar dropped to 94.50 US cents, down from 94.80 US cents. but the market is likely to reassess once it has digested the changed emphasis from the bank towards rates.

With oil over $US122 a barrel and other commodities stronger, the Aussie dollar rebounded to within sight of 95 US cents.

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Published on May 5-th, 2008 in Home Loans
Damon Rasheed is the CEO of Rate Detective, an Australian financial service comparison sites specialising in Life Insurance, Income Protection Insurance and home loans. Damon holds a Master's Degree in Economics from the University of Melbourne and has been involved in many start-up internet businesses.
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