Wednesday, July 25, 2007

It's on: A pre-election interest rate hike!

An unexpected boost in inflation has made a pre-election hike in mortgage rates a near certainty.

The board of Australia’s Reserve Bank will meet to consider the increase in twelve days time on Tuesday August 7, the day that parliament resumes after the winter break.

The rate increase – the fifth since the 2004 election fought and won by the Coalition on a promise of keeping interest rates low - would be announced the next morning at 9.30am...

It would take the Bank’s target cash rate up to 6.50 per cent from 5.25 per cent at the time of the last election, and the standard variable mortgage rate up to 8.30 per cent for borrowers not enjoying a discount, adding a further $60 to monthly repayments on a $400,000 mortgage - $380 more than at the time of the election.

The so-called “core” rate of inflation, which excludes volatile prices jumped from 0.6 per cent to 0.9 per cent in the June quarter, pushing the annual rate to 2.8 per cent, right at the top of the Reserve Bank’s target zone.

The news pushed up the Australian dollar more than half a US cent to 88.60 US, its highest level in 18 years.

A frenzy of trading in bank bill futures pushed up the market’s implied probability of a rate hike on Wednesday week to 80 per cent. The implied probability of a rate hike within the following four weeks is 100 per cent.

Both the Prime Minister and the Treasurer yesterday played down the prospect of an rate hike. Mr Howard said that at 2.8 per cent, Australia’s core rate of inflation remained within the Reserve Bank’s target band of 2 to 3 per cent. “What I am saying to you and what is obvious it that it is still well within that range”, he said.

The Treasurer Peter Costello said that prices were increasing more slowly than at any comparable period in Australian history.

Asked whether he accepted the right and responsibility of the Reserve Bank to increase interest rates in order to keep inflation in check regardless of the imminence of an election, he replied, “You are asking the Pope whether he agrees with Catholicism. I put in place the independence of the Reserve Bank.”

The 0.9 per cent June quarter increase in the Reserve Bank’s preferred core measure of prices is one of the highest since the 1980’s. In the last 12 years it has been topped only once, in June 2001, in the lead up to the GST.

The Commonwealth Bank’s chief economist Michael Blythe said that was surprised him was the breadth of the price increases – extending to items such as furniture and clothing and footwear that the high Australian dollar had been expected to make cheap. Rents were up by 1.6 per cent in the quarter, 5 per cent over the year, the biggest increase in about two decades.

The Macquarie Bank’s Rory Robertson, himself a former Reserve Bank staffer, told clients in a note that the decision facing the Bank was not at all complicated.

“The Australian economy is enjoying once-in-a-lifetime commodity price and terms of trade booms. Unemployment has pushed down to a new three-decade low with the labour market is unusually stretched. Consumer and business confidence are elevated, and city-average home prices are rising at or near double-digit rates in most capitals.”

He said the Governor Glenn Stevens had as good an opportunity as he ever would to kill forever the myth that the Reserve Bank did not hike in an election year.


Why is it as good as certain that Reserve Bank will push up interest rates within a fortnight notwithstanding the looming election?

Because it has been minded to do so for months.

Back in March the Bank dropped very broad hints that it would act as soon as it saw a hint of runaway inflation. In June the Governor agreed in answer to a question that Australia’s economic growth rate had become “unsustainable”.

But until now, so far this year Australia’s official inflation figures have remained stubbornly low – failing to provide the smoking gun the Bank needed to make the case for a rate hike unassailable.

Yesterday’s June Quarter inflation figures provide it on a platter. Officially prices (and probably wages, although we won’t know for sure until those figures are out on August 15) are now accelerating as the Bank would expect in a once in a generation economic boom.

There is next to no risk of another hike bringing on a recession, and every risk that if the Bank does not hike, inflation will get away from it.

The Treasurer Peter Costello has successfully insulated the Bank Governor Glenn Stevens from any prospect of political interference. In September last year he placed him on a seven-year contract. Charged with containing inflation until 2013 the new 49-year old Governor knows he is likely to outlast Peter Costello as well as John Howard and perhaps both of their successors.

The hike in interest rates that he is about to inflict will cause pain, and the Labor Party is certain to dwell on it in its exquisitely-timed housing affordability summit to be held this morning.

But the Reserve Bank isn’t charged with avoiding pain. It is charged with maintaining full employment and price stability. Full employment is not at risk. The Bank may even take the view that employment is over-full.

A breakout in inflation is very much a risk, and much of it can be sheeted home to the Government and the way it has handled its once-in-a-generation resource boom bounty. It has delivered tax cuts in 2003, 2004, 2005, 2006 and 2007 and budgeted for more cuts in 2008. Party in order to restrain the spending those cuts would engender the Bank has had to hike rates in 2002, 2003, 2005, 2006 and now almost-certainly 2007.

The Bank might well feel that if the Government had genuinely wanted to avoid interest rate hikes it wouldn’t have annually stoked the fires of consumer spending.

Only one thing has any real prospect of stopping the Bank what doing what it has long felt the need to do when its Board next meets on August 7 – some sort of international economic meltdown, perhaps emanating form a crisis in the US home loan market.

That such a prospect, in the next fortnight, is now considered the most likely obstacle to an August 7 rate hike shows just how much of a sure thing it has become.