RBA still expected to raise cash rate on 4 July

RBA still expected to raise cash rate on 4 July

RBA Governor Glenn Stevens today delivered a speech and answered questions at a business forum in Brisbane. The Governor stuck closely to the tone of the RBA's May quarterly statement that signaled that, while interest rates were more likely to rise than fall, there was no urgency to adjust policy. In this way, the Governor's speech reveals that the tightening bias remains firmly in place, but officials believe they still have time on their side, mainly because the starting point for the expected acceleration in inflation in 2008 is lower than previously thought. Even though the Governor today provided no clear support for an early policy tightening, we retain our forecast that the RBA will raise the cash rate 25bp on 4 July.

Our expectation for today's speech was that, following market over-reaction to official commentary back in March, the Governor would tread extremely carefully - and he delivered. The Governor's apparently relaxed stance today means that a July move requires things to change quickly in coming weeks. This could take the form of further increases in energy prices owing to the lack of water, a spike in food prices, or unexpectedly strong readings on the credit and retail trade data that precedes the July Board meeting. One thing is crystal clear, the Governor's references to anxiety about medium term inflation means the RBA is nowhere near cutting interest rates.

Although our call for a July rate hike received no support today, there were morsels in the Governor's speech suggesting that a July move should not be ruled out (in the wake of the speech, futures market pricing implies zero probability of a July move). Conspicuously, the Governor twice made reference to the RBA Board's assessment of policy 'month by month', which hints at a possible break in the nexus between CPI reports and policy moves - this separation is necessary if the RBA is to tighten in July in the absence of a 'smoking gun' CPI report. Also, the Governor made reference to how lingering medium term inflation risks give rise to questions about whether current policy settings are 'restrictive enough'. Taken literally, this could be interpreted as a hint of anxiety about whether the RBA should have tightened earlier this year, when the majority of economists (not JPMorgan) forecast a hike and market pricing was supportive.

On the flipside, though, the Governor immediately posed the counter argument that the low starting point for inflation affords policymakers additional time. In essence, our call for a July tightening assumes RBA officials currently underestimate the stress the economy is under, and the extent of upside price pressure being generated. The accumulating upside risks to inflation are likely to become more apparent in the week's ahead of the July Board meeting when, in particular, the degree to which the Murray Darling Basin is to be drained will become clear, and the persistence of the drought-induced rise in electricity and gas prices can be determined. For now, the RBA seems comfortable that the plunge in the jobless rate is not triggering wage pressure, but anecdotes from companies indicate that the shallow pool of available workers is triggering wage pressure, albeit slowly.

For the record, our core argument for a near term tightening comes from the deterioration in the medium term inflation outlook owing to the recent spike in electricity, gas and petrol prices and the likely bounce in food prices if, as still expected, irrigation flows to Australia's food bowl are slashed from 1 July. On top of this, we believe the drum-tight labour market will trigger an acceleration in wage growth in coming quarters. Also, the economy growing much faster than potential - as the Governor indicated today, supply responses are not infinite and persistently strong growth in demand eventually will trigger wage and price pressure. On top of this, the fiscal boost from government spending is growing by the day and, as the Governor appeared to indicate, downside risks to global growth have faded.

The advantage of a preemptive July move is that it gets it out of the way well ahead of the Federal election, which will be held towards end-year, and before the release in late July of the Q2 CPI, which almost certainly will show a sharp fall in the annual rate of inflation, owing mainly to beneficial year-ago base effects. If the RBA is edging slowly towards a pre-election move, July is the only workable option. A rate hike in August would be awkward to explain immediately after a plunge in annual inflation, and a post-August move risks policy becoming unnecessarily entangled with the political cycle. We expect a second tightening in February 2008 once the election is out of the way and these inflation base effects have unwound.

ENDS

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