Australia and New Zealand Weekly Prospects

(See attached file: AusNZ_weekly_300707.pdf)

* Last week's upside surprise on Australia's core inflation prompted us to drag forward the two tightenings we expected in 2008 - we now expect rate hikes in August and December. Core inflation still is running in the upper half of the RBA's 2-3% target range - this should be enough to trigger a tightening next month, even though headline inflation fell to just 2.1%oya. We had believed RBA officials could wait until after the election, but the inflation data was too compelling to ignore. Not tightening now risks rates having to rise even more assertively in 2008. This week sees key releases on credit, retail sales, building approvals and trade. The deteriorating outlook for inflation means not even material downside surprises could convince the RBA to be inactive in August.

* The RBNZ last week hiked the official cash rate (OCR) to an unprecedented 8.25%. The statement announcing the policy change was less hawkish than expected, with officials stating that the four tightenings this year should be enough to turn inflation. The more neutral commentary was, however, conditional on decelerating credit growth and easing pressure on resources. The risk of further tightening later this year (most likely in October) remains at 30%.

* Repricing of risk in the past two weeks has led to a big drop in equities and a rally in government bonds. Market participants' wholesale shift to risk aversion, while apparently driven by credit market conditions specifically, creates renewed uncertainty about the next move in global growth. Activity indicators have surprised on the upside in Asia , and have remained solid in Europe, but concerns about US growth remain intense. These revolve around both the direct impact of further housing weakness on residential construction and the indirect impact of a broadening of the associated credit problems. Not surprisingly, the strong bounce in 2Q GDP in the US has done little to ease these concerns, partly because of the potential feedback effect of a weaker stock market on US consumers.

* While not downplaying the increased downside risks to growth, it is important to recognize the strength of the global economy at midyear. The US economy ended 2Q with both ISM surveys at their highest levels in a year, and the decline in initial jobless claims through the first three weeks of July suggests that growth may be accelerating, not weakening. The main risk to our view is that broadening credit problems weigh more heavily on equity markets, damp households' ability to smooth consumption through transitory income shocks, and ultimately lead to a retrenchment in aggregate demand. We expect this risk to ease, though, over the next several weeks as credit markets stabilize and liquidity returns.

ENDS

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