Tuesday, February 12, 2008

Going up. What the Reserve Bank Statement says

Australia's Reserve Bank has effectively pre-announced its next interest rate hike.

Declaring that only something approaching a collapse in the economy would prevent it from acting, the Bank yesterday broke with tradition and used its Quarterly Statement to explicitly set out its plan to push up rates.

It said that “absent a further shift in economic risks to the downside” interest rates would “need to be tighter”.

The Bank also sharply lifted its inflation forecasts and for the first time set out detailed projections for the next three years, concluding that without a further hike in interest rates, inflation would stay beyond the reach of its target band until into the next decade.

It expected inflation to hit to 3.5 per cent by the middle of this year and not to fall back to 3 per cent (the top of its band) until June 2010...

The Statement expressed alarm that even that forecast might prove to be optimistic.

It said that if the economy was to prove stronger than expected even the forecast of a return to 3 per cent by mid-2010 would be “unlikely to eventuate with the current policy settings.”

Signaling that it has become worried about losing control of inflation altogether the Bank's Statement said, “most importantly, if it is not reversed reasonably quickly, the recent pick-up in inflation carries the risk of generating an upward drift in inflation expectations”.

The Bank reported that when surveyed households now typically say they expect an inflation rate of 4.3 per cent, well up from the average of 3 per cent over the inflation-targeting era.

Westpac's Chief Economist Bill Evans said he was “shocked” by the Bank's obvious extreme concern.

“Even by June 2010, the expectation is only that inflation will be back at 3 per cent, the top of the target band. The decision to highlight specific point forecasts so far out emphasises how worried the Bank must be,” he said.

Dr Evans expects another interest rate hike in March when the Bank's board next meets in three week's time.

“There would appear to be no longer any doubt within the Bank that Australia has an inflation problem. Consequently, waiting for further news on the current inflation data would appear to be unnecessary,” he said.

A further rate rise in March – the fourth in just seven months - would result in mortgage rates more than one complete percentage point higher than they were in August. A $400,000 mortgage would have become in excess of $300 a month more expensive to service.

The Treasurer Wayne Swan said that the Bank's Statement steeled the Government’s resolve to attack inflation.

“These forecasts are up to half a percentage point higher than those contained in the November Statement. The higher expected inflation is the result of price increases that have already occurred and the expectation that pressures on capacity will remain for some time,” he said.

The Prime Minister Mr Rudd said it was a “disturbing warning”.

The Bank Statement said that Australia's iron ore and coal prices were set to climb a further 40 to 50 per cent in the year ahead, adding a further 5 to 10 per cent to Australia's already historically high terms of trade.

Average wage earnings were now increasing at 5.9 per cent per annum, the fastest rate since 1996.

The Shadow Treasurer Malcolm Turnbull called on the government to guarantee that its planned industrial relations would not fuel inflation further.