RBA: No inclination to rock boat before storm

If the Reserve Bank of Australia board focuses only on its interest rate decision for tomorrow, it will require only a very short meeting. There is no appetite to rock the boat either in the financial markets or (as far as public utterances would suggest) in official circles.

Although we think that interest rates should have been higher earlier, and as a result rates might by now be coming down, there seems no immediate need to move rates in either direction from the present 5.5 per cent.

The board might as well enjoy this calm before the storm clouds build up again. And they are building, both overseas and at home.

Take the global economy first. The US Federal Reserve has increased the US Fed Funds rate to 3.25 per cent and has issued an explanatory statement that makes clear that further rate rises are likely. The US economy's growth is "firm", monetary policy is still "accommodative" and policy accommodation can go on being removed at a "measured" pace. Indeed, we read the Fed as signalling a more hawkish line.

Add to this the upturn becoming more evident in Japan, the continuing growth in China at a 9-9.5 per cent annual rate, and the success in stimulating growth in Latin America and Eastern Europe (if not in old Europe itself), and it is hard to argue that global economic conditions are deteriorating.

The outlook for inflation is harder to read. Oil and some other commodities have been at levels that signal inflation. Global liquidity has been running at double-digit rates, although slowing somewhat after two years at 20 per cent. Wages are held down by competition from Chinese and Indian workers, but productivity seems to be slowing in the manufacturing industries of major Western nations. The RBA governor would appear to agree at least about the outlook for global activity, as he recently spoke of the global economy only being in the early stage of a broader upturn. This suggests to us that the RBA has retained its tightening bias even though it has hung up its cue for now.

To our minds, the now legendary Bond Market Conundrum (BMC) - i.e., the anomaly that US bond yields have fallen rather than increased as the US Fed has tightened - will resolve itself shortly.

The low US bond yields have served to inflate other financial asset prices, notably equities (globally) and house prices (in the US). But the low bond yields are predicated on the Fed not tightening much more, and the level of uncertainty remaining at historically low levels.

If the Fed tightens further, as seems most likely, these underpinnings of the BMC will evaporate and the so-called "risk-free" rate will prove to be not so risk-free after all. Any disappointments in corporate earnings will then savage equity values. Why might corporate earnings disappoint? Maybe "firm" economic growth will not prove quite sufficient, wages growth accelerates or productivity growth sags.

International risks include the burgeoning "twin deficits" in the US, the global housing boom, with its clear opportunity to turn into a bust, the possibility of a more-sudden-than-now-expected return to "normal" interest rates in the US or a major trade war between China and the US.

At home, the month of July will see everyone with more data, although not necessarily better informed. Consumers are reawakening after the sluggish patch in the early months of the year, reassured about what they have been told about the interest rate outlook and the prospect of tax cuts. We do not expect consumers to be unsettled by the proposed new industrial relations landscape, union protests notwithstanding. Retail sales and housing approvals bounced back in May. Job vacancies fell slightly after an exceptionally strong increase in April, and are still running at double-digit rates.

The inflation data for the second quarter (both consumer prices and producer prices) will show more worrying increases, only partly due to the recent surge in oil prices. In time, the failure of the Australian dollar to continue to appreciate (despite record terms of trade) will see non-traded goods and services prices come to dominate the headline CPI figures. Indeed, with wages growth rising and zero or negative productivity growth, inflation into 2006 is set to rise well clear of the upper edge of the 2-3 per cent target range.