Rate rise scratched - RBA Board on Cup Day, 2005

Wait for the sound of the second shoe dropping. The Reserve Bank Board will do nothing today - a toast to the winner of the Melbourne Cup will be the board members’ most energetic action.

But all focus will be on the thoughts that go into the Monetary Policy Statement that will be released in a week, on November 7. We expect the shoe to hit the ground with a thump.

Last month we forecast the script of this pantomime.

Good cop, Governor Ian Macfarlane, had already laid out the case for a continuation of strong global growth, funded by Asian excess savings flowing to the US (and Australia), so profligate habits could be retained.

Bad cop, Deputy Governor Glenn Stevens, did pretty much as we had suggested. On October 11 in Tasmania, he translated this “good global news” into a series of rhetorical questions about how inflation could be expected to remain low in Australia if growth of local demand and output remained so strong.

Stevens was careful to ensure that he did not answer the questions, but anyone who thought through the issues will have put their money on an expectation of rising inflation and consequent interest rate action from the RBA.

In the event, the market may have got a bit carried away. After the speech, a 50 per cent chance of a rate increase in February or March had been priced in. This expectation was then knocked out of the pricing ring by the “shock” that the headline rate of inflation in the September quarter was “only” the 3.0 per cent already released by TD Securities and the Melbourne Institute in their monthly index of inflation for August (the mid-month of the September quarter), rather than something higher.

But it is not insignificant that the CPI is at the ceiling of the target range. Even with the welcome modest easing in oil prices in both the spot and futures markets, the portents for inflation are ominous. Measures of core inflation have crept up to the middle of the target range and the exchange rate is generally expected to not appreciate enough to prevent inflationary pressures bubbling over the top of the range.

We continue to believe that the RBA made a bad mistake when it moved in August from its tightening bias to its claim that there was as much chance of rates falling as rising. To be sure, there have been a few discordant weaker signs, including the decline in employment in September. But overall, aggregate demand remains well above supply and the boom in the mining states seems to be more than offsetting the disinflationary sloth in Sydney and Melbourne. We see the November Monetary Policy Statement as the RBA’s first formal opportunity to make amends for its August error.

One of the most significant events of the month that has elapsed since the last RBA Board meeting has been the nomination by President Bush of the head of his Council of Economic Advisors, Professor Ben Bernanke, as heir to Alan Greenspan as head of the US Federal Reserve. Hopefully for the peace of mind of financial markets, which have generally been only a little discomforted with the idea of Bernanke, he does not meet the fate of Bush’s family lawyer as nominee for a seat on the Supreme Court.

We consider Bernanke a fine appointment, in tune with the best traditions of scientific inquiry that are required of central bank governors. He is going to face challenging times. His honeymoon seems to be already over, even before he has been confirmed in the post.

Since his nomination, US bond yields risen on the fear that he may be a little softer on inflation that his predecessor - a view that seems quite mischievous given the market’s more normal paranoia about the “Greenspan put”.

In addition, the schism between the “let consenting adults decide what they spend and suffer the consequences” approach of Alan Greenspan and Ian Macfarlane and the conventional wisdom that current account imbalances must be closed willy nilly has been starkly highlighted by the hike in interest rates to 7.0 per cent in New Zealand. Dr Alan Bollard of the Reserve Bank of New Zealand has taken the authoritarian approach that Kiwi spending on houses and imports is unsustainable and must be curtailed.

Not all the news is bad, though. Perhaps the best, beyond the realisation that the US has cloned a virtual Ian Macfarlane as its central bank governor, is the continuing signs of recovery in Japan, where only inflation refuses to show its head. Further afield, the news has also improved, with Germany finally sounding as though it wants to get to work.

The rise in bond yields, which has seen US equities begin to fall from over-inflated levels, will gradually cut into US economic growth, but it will be a great victory for Alan Greenspan and for international policy coordination if the US slowdown is offset by Japanese and European recovery.

China - as ever - is still booming, disappointing the pessimists who can’t wait to see it fall over. China even seems likely to pay more for its iron ore imports next year while it continues to charge less for its exports.

So the sun still shines a bit on the RBA Board’s track. Once again, today, the RBA Board can metaphorically go to the races. We see no prospect that the RBA will choose to surprise markets tomorrow. Rate moves in future will be well telegraphed.

The November statement next week will be just one stepping stone on that path. The governor is addressing Australian Business Economists on December 13 and the recent developments suggest he should be giving business economists an early Christmas present on his revised thinking. We suggest he focus on how quickly US rates are catching up with Australian rates, and trace through the depressing consequences for the Australian dollar, which takes away the excuse to hold rates below normal Down Under.

There needs to be plenty of jawboning before the year is out, in order that the rate rise in February or March is virtually a yawn. The RBA will want to avoid at all costs the public and political outrage that followed its essential, but perhaps inadequately telegraphed, move in March of 2005 to hike rates by 25bp.

Source: www.henrythornton.com from RBA data.