Monday, November 2, 2009

Australian & New Zealand Weekly

Week beginning 2 November 2009

  • RBA: Case for 50bp hike next week still solid but rates on hold for much of 2010.
  • Australian data: house prices, retail sales, dwelling approvals, trade previewed.
  • Some subtle shifts from the RBNZ.
  • US FOMC to leave rates and statement unchanged.
  • ECB on hold; BoE to also leave rates unchanged but QE extension likely.
  • US data: ISMs, construction, jobs data due.
  • Key economic & financial forecasts.

Australia: Case for 50 bp Hike Next Week Still Solid - but Rates on Hold for Much of 2010

The Reserve Bank Board meets on November 3. Markets and most economists expect the Board will choose to follow the 25bp rate hike which was delivered on October 6 with a further 25bp's following the November meeting.

After flirting with up to 50% probability of a 50bp rate hike at various times over the last month, markets are now giving it only a 10% probability.

We beg to differ. Our analysis of the rhetoric of the Governor's speeches and the October Board Minutes indicates a more urgent approach to policy than implied by market pricing.

The case for a larger than expected increase is always strongest at the early stages of the tightening cycle. The risks of tightening too much are at their lowest when rates are at record lows; the risks of tightening too slowly are also high when policy is at its most stimulatory since imbalances are more likely to emerge.

Imbalances emerging

Those imbalances are most apparent with goods and services inflation and asset price inflation.

The report from Australian Property Monitors that house prices increased by 3.7% in the September quarter - the strongest gain in six years - to be up 7.1% for the year is likely to be unnerving for the Bank. Record increases in house prices when rates are near record lows would not sit well with a central bank.

The goods and services inflation story should also be of concern to the Bank.

That was demonstrated with the print of the September quarter CPI last Wednesday.

The importance of the inflation number clearly relates to the Bank's current forecast that underlying inflation will bottom out at 2.0% in 2010 from the current level of 3.5%. The evidence from the number is that over the last 12 months, despite a substantial slowing in the economy and a near collapse in headline inflation, the average measure of quarterly underlying inflation has been 0.86%qtr. The September quarter read of 0.8% qtr shows precious little slowing - hardly consistent with the current extremely expansionary stance of monetary policy.

True, over the year underlying inflation has come down from an average of 1.16% for the previous four quarters (Q4-07 to Q3-08), but the major factor behind that shift down has been petrol prices; rents; deposit and loan facilities; and house building costs. Weakness in these components also explain the bulk of the collapse in headline inflation to 1.3%. These components, however, are already turning.

In the September quarter petrol prices rose by 4% after falling by 22% over the previous 12 months; house purchase cost inflation increased from -0.5% in March to 1.1% in September; rent pressures eased further from 1.7% in March to 1.2% in September but the pace of slowdown in rents has clearly moderated substantially; deposit and loan facilities, which fell by around 20% over the previous three quarters, rose by 3% in September.

Certainly other components of the CPI may now take over to drive the next down leg in inflation which the Bank patently needs.

Presumably these pressures will come from demand-related sources and the rise in the currency. However the evidence in the September release was not encouraging.

Scrutiny of the details of the September quarter print shows that there were significant upside surprises on demand-driven price components - housing; clothing and footwear; furniture and major appliances; cars; sports equipment; toys games hobbies. With an average increase in the AUD of 6.5% in the September quarter following a 9% rise in the June quarter it appears that importers have been able to take advantage of demand conditions to restore margins. That hardly augurs well for the Bank's current forecast that underlying inflation will fall from 3.5% to 2% next year.

Indeed the September release is almost certain to force the Bank to raise its low point forecast for underlying inflation next year from the current 2.0% to 2.5% at best - any lower number would lack credibility given the Bank's assessment that growth will return to trend in 2010 and strengthen thereafter. (Chart 1)

A more credible estimate of, say, 2.75% would be untenable. A central bank would hardly forecast that the low point in its inflation profile would be well above the middle of the 2-3% "on average over the cycle" target zone.

So why wouldn't the Bank choose to accelerate its tightening process at the safest possible time when rates are near record lows? The answer is presumably because the Bank is much more sanguine about the risks we describe above than we assess it to be and, after all, the art of picking near term movements in rates is to best understand the current thinking of the Bank.

Strong rhetoric

In that regard we can only rely on recent public Statements; speeches and reports from the Bank. Sanguine is hardly the description of sentiment in those communications.

The Reserve Bank Governor's speech delivered on October 15 on "The Conduct of Monetary Policy in Crisis and Recovery" and the October Board Minutes have emphasised to us the urgency the Bank sees for the need to be moving rates back to more normal levels. While the Governor's Statement following the 0.25% increase in the cash rate on October 6 noted, "it is now prudent to begin gradually lessening the stimulus provided by monetary policy" the Minutes did not include the key word "gradual".

Extensive analysis of the Governor's Statement highlighted the word "gradual" as the key message word. Surely if the Bank wanted to entrench that thinking it would have repeated that word in the Minutes - yet it was significantly absent.

This could reasonably be interpreted as a very intentional decision to raise the alert that the situation had become more urgent.

The language from that speech was certainly strong, "If we were prepared to cut rates rapidly, to a very low level, in response to a threat but were then too timid to lessen that stimulus in a timely way when the threat had passed we would have a bias in our monetary policy framework".

We also note that, quite unusually for a central banker, he was prepared to question the veracity of the official inflation forecasts: "In fact, in late 2009, we are still to see whether inflation will be consistently back to target over a period of time. We think it will be, but, as yet, that remains a forecast." Our analysis above certainly endorses that sentiment.

The Board Minutes went further, "The balance of risks was now such that the current very expansionary setting of policy was no longer necessary and possibly imprudent".

Our read of the Bank's current mood differs from the market's. The market, presumably, is interpreting this strong language as no more than deliberate justification for beginning the tightening cycle before any other major central bank rather than providing any future guidance.

Recent overseas developments must also be raising the Bank's level of anxiety. Since the Governor's speech and the release of the Minutes annual growth in China has been restored to 9% and today we see the print of GDP growth in the US of 3.5% (annualised for the September quarter) - the first positive since June 2008 and well above market expectations.

We see the case for the bank tightening by 50bp's on November 3 to be followed by a further 25bp's on December 1. That will restore the overnight cash rate to 4%.

Outlook for 2010

Another couple of 25bp increases can be expected in the first half of 2010 with the cash rate to reach 4.5% by around May. With rates back to more normal levels and lead indicators such as consumer and business confidence and housing finance approvals (driven by both weakening demand and constrained credit supply) softening we would anticipate a pause for the remainder of 2010.

Note however, that our forecast peak in 2010 is still well below current market expectations of 5.25%.

Chart 3 explains our view. It sets out our estimate for the household debt servicing ratio under the scenarios of our rate forecast and the market view.

We assess that if market pricing for the cash rate is correct then the household debt servicing ratio will exceed 2008 levels when the RBA cash rate reached 7.25% and proved to be so crippling for Australian households. As discussed we expect that confidence; house prices; and new lending would have reacted well before that peak eliminating the need for the Bank to press on in its tightening cycle through the second half of 2010.

Bill Evans, Chief Economist


There are precious few precedents for the market expecting a 25bp hike and being wrong with a 50 being delivered, but there is one. In February 2000 following the first move in a new tightening cycle of 25bp's in November 1999 the market was certain that a second 25bp would be delivered. In the event the RBA delivered 50bp's. This was partly driven by a sudden change in the international environment - not dissimilar to today's surprise jump in US GDP. Of course the base was much higher than today with the rate going from 5% to 5.5%.

Since then there have been 16 rate hikes and all have been by 25bp's - but rates have never been this low and, as discussed, potential imbalances and official rhetoric have never been as strong.

New Zealand: Week ahead & Data Wrap

Suspended sentence

The RBNZ's decision to leave the cash rate on hold at 2.50% came as no surprise, but the focus was on whether they would alter or replace the 'bias' sentence at the end of the statement.

In recent statements, the RBNZ have noted that "we continue to expect to keep the OCR at or below the current level through until the latter part of 2010." Our view was that, with the recovery unfolding rapidly, the RBNZ would give themselves more flexibility with a statement along the lines of "it is appropriate to keep the OCR at low levels for a considerable period". This would have both given them some breathing room in terms of the timing of rate hikes, and recognise that even a few hikes would still leave the OCR at abnormally low levels.

In the event, there were some cosmetic changes but the thrust of the statement was broadly unchanged. The first change was that the last vestiges of an easing bias were removed, with "at or below the current level" becoming "at the current level". The second change was that "the latter part of 2010" became "the second half of 2010". Arguably these words are synonymous, but compared to the interest rate projections in the September Monetary Policy Statement, which were consistent with no hikes until Q4 2010 at the very earliest, the latest statement allows for the possibility of hikes by Q3 next year.

The RBNZ acknowledged the continuing improvement in both global and domestic activity. But once again they raised concerns that the recovery is being skewed towards domestic demand and away from exports - without shedding any light on what this means on balance for monetary policy. Our view is that since domestic demand bore the brunt of the recession, while exports held up relatively well, the recovery will inevitably be skewed towards those sectors that have the most ground to make up.

The emphasis on keeping the cash rate unchanged for an extended period leaves an important question unanswered: what happens when they do start raising rates? Recent comments from the RBNZ have given us the strong impression that they lean towards moving rates late and hard, rather than early and gradually. This was touched upon in the September MPS projections, which indicated a fairly steep tightening profile beyond late 2010 - putting the 90-day rate at 5%, and rising fast, by the end of the forecast horizon in early 2012.

This approach would seem to put the RBNZ at odds with many other central banks that favour a pre-emptive approach - especially in light of the fact that policy rates are still at 'emergency' settings, when the emergency has passed. The RBA and Norges Bank have begun raising rates on this basis, ECB officials have commented on the need to act early, and there's even speculation that the Fed will look at rewording its commitment to low rates at next week's review.

This week's statement was also notable for the way that the RBNZ explicitly placed themselves in opposition to market pricing for rate hikes next year - before the statement, interest rate markets were picking January next year for the first rate hike; this timing has since been pushed back to March. That's still significantly earlier than what the RBNZ has signalled, but it doesn't mean that the market is deliberately challenging the RBNZ. On the contrary, our experience is that the speculative market has had some sympathy for the RBNZ's view, but traders have been repeatedly cleaned out as the domestic data has turned out stronger than expected.

We expect the data to maintain that generally positive tone over coming months, and we remain of the view that by March the RBNZ will have seen enough to be convinced that it's time to start moving policy away from 'emergency' settings. The RBNZ do have some time on their side, with the economy running below capacity and inflation comfortably within the target - but we don't think that latitude extends to the second half of next year.

Turning to this week's data releases, business confidence was a touch lower in October, but still near its highest in ten years. The details of the survey showed further improvements in expected profits and investment and export intentions, although employment intentions remained broadly flat. Confidence was also a little less broad-based than in September - most sectors were more cautious, perhaps due to the recent strength of the currency, but the construction sector was remarkably fired-up.

That confidence will be needed to propel the pickup in residential construction that we think is needed over coming years. Building consents rose another 3.3% in September, with a strong lift in apartment consents from unusually low levels. However, consents are still running at less than half of the peaks reached in early 2004.

The September trade deficit of $424m was in line with our expectations, although both sides of the ledger showed the effects on prices from the stronger NZ dollar. Milk powder exports were also held back by seasonally low production and the sharp rundown in stocks earlier this year.

Next week's data is centred on the labour market. The various wage measures (Tues) are likely to remain subdued, reflecting their status as a lagging indicator. We expect the unemployment rate (Thurs) to rise from 6.0% to 6.5%, though this will be the last major quarterly increase. Hours worked are expected to rise, as employers respond to the recovery initially by increasing the hours of existing workers.

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