THE BIG PICTURE: Why the RBA is still inclined to cut rates

The Reserve Bank always provides a statement accompanying its interest rate decisions. But that still has left plenty of economists scratching their heads for reasons why rates were left on hold this week. A survey by Bloomberg showed that 24 of 27 economists tipped rates to fall. So how did they all get it wrong?

Overall the Reserve Bank opted for a strategic decision rather than one based wholly on economics. Certainly the economic case for a rate cut was compelling. Inflation is under control and expected to stay that way. In addition the latest data shows that consumers aren’t spending, or buying and building homes. The Aussie dollar is high, putting pressure on businesses. And interest rates are slightly above long-term averages.

A 25 basis point rate cut would have given the economy a much-needed kick along, without threatening the inflation outlook. And it would have provided much need insurance to Australia in a world dominated by jitters about the European debt crisis.

But what about the other side of the equation? There are signs that the European situation is stabilising – certainly sharemarkets are lifting. China looks to have achieved a soft landing with inflation under control and economic growth at a more sustainable pace. And US economic data has been encouraging. So if times are getting better, why cut rates?

Of course the European situation could go pear-shaped. And if that’s the case, there were even more reasons to conserve rate cut ammunition.

Then there is the issue of bank funding costs. The Reserve Bank knew that there was a significant risk that banks wouldn’t be able to pass on all, or some of, a 25 basis point rate cut. So they may have decided that it was better to hold off on a rate cut for a month or two when banks may be a better position to cut rates.

Some have also suggested that rates are only cut if the economy is struggling – and the Reserve Bank didn’t share those views. But the recent rate cuts were not delivered just because the economy is struggling, but also because tighter policy isn’t required when inflation is well behaved. It is the level of rates that matters. Rates are slightly above long-term averages and that’s why the Reserve Bank still maintains an easing bias.

The week ahead

A packed program of economic and financial events is on offer in both Australia and the US over the coming week.

In Australia, data on housing finance is released on Monday together with the Reserve Bank figures on credit and debit card lending. The number of loans to home buyers (as opposed to investors) probably rose by 2% in December with the value of all home loans up by around 1%. Rate cuts in November and December helped. And expect data to show that credit card lending remained subdued at Christmas time.

On Tuesday Reserve Bank Assistant Governor (Financial markets) speaks at the Bloomberg Financial Markets seminar. And on Wednesday lending finance and car sales data are due for release. We expect that car sales rose by around 1% in January – good but not great.

And on Wednesday, Westpac and the Melbourne Institute release the February consumer confidence data. Expect a flat result following the decision not to cut rates this month.

On Thursday Reserve Bank Assistant Governor (Economic) Philip Lowe speaks to the Committee for Economic Development of Australia, Economic and Political Overview forum. Hopefully he can provide some non sanitised insights into the recent interest rate decision.

Also on Thursday, monthly employment data is issued. We expect that jobs rose by around 15,000 in the month with the jobless rate edging up from 5.2% to 5.3%. The other piece of the puzzle is hours worked – but a harder variable to forecast. If data shows slightly fewer jobs were created in January, but more hours were worked by existing employees, this would still indicate the economy is going ahead. Simply, businesses are reluctant to take on new staff and prefer to work existing employees longer hours.

In the US, the week kicks off on Tuesday with data on retail sales, import and export prices and business inventories. The US economy is on the mend – and this should be demonstrated by a 0.6% lift in retail spending (excluding autos, up 0.5%).

On Wednesday, industrial production data is released and economists tip a solid 0.6% gain. The Empire State index and capital inflows data are also released together with minutes from the Federal Reserve meeting held on January 25.

On Thursday, data on housing starts and producer prices are released together with the influential Philadelphia Fed index. Economists tip a 0.2% lift in core prices (excludes food and energy) and a 2% rise in housing starts.

And on Friday the leading index is issued together with data on consumer prices. The leading index may have risen by a healthy 0.3% in January while core consumer prices probably rose by 0.2%.

Also of note in the coming week, Monday is the deadline for Greece and its private sector bondholders to hammer out an agreement. And while Federal Reserve chairman Ben Bernanke delivers a speech on Thursday, he doesn’t have the same pulling power in the current environment with interest rates near zero.

A raft of government debt auctions are held in the coming week including Italy, Germany & France (Monday), Italy, Greece & Spain (Tuesday), Portugal (Wednesday) and France (Thursday).

Sharemarket, interest rates, currencies and commodities

The Australian profit-reporting season cranks up a notch in the coming week. On Monday, JB Hi-Fi report together with SingTel and Leighton Holdings. On Tuesday, GWA Group is amongst those listed together with Hills Holdings, Paladin Energy and SAI Global. On Wednesday, Commonwealth Bank will report earnings alongside The Reject Shop, Primary Healthcare, Flexigroup, Domino’s Pizza, Westfield, Fortescue Metals and OZ Minerals.

A bumper day of profit results is slated for Thursday including Adelaide Brighton, Goodman Fielder, Wesfarmers, Qantas, Brambles, AMP, Alumina, ASX, Goodman Group and QR National. And on Friday, Billabong, Santos, Spotless and Treasury Wine Estates are listed.

How views have changed on interest rates. A 25 basis point rate cut is now not fully priced in to the overnight indexed swap market until around July or August. And this is backed up in the bank bill futures market where the implied yield on the June contract is 4.13%.

Clearly the Aussie dollar received a boost from the decision to leave rates on hold. Before the rates decision, some were debating whether the Aussie could slide to parity. Now there are expectations that the Aussie will hit new 30-year highs above US110 cents and go even higher. Certainly these are troubling times for Australia’s beleaguered manufacturers.

Not only is the Aussie dollar creeping towards multi-decade highs against the greenback, but the Aussie is also near multi-decade highs against most major currencies. The trade weighted index stands at 78.8, not far off the 27-year high of 79.2 set on May 2 last year.

Craig James is chief economist at CommSec.


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