Brace for rate hike - unless ...

The case for at least one more rate hike has been clear for some time. The global economy is strong, and global inflation is rising. China’s economy is overheating and China has gone from being a global source of deflation to a generator of inflation. Like many more developed nations, China is tightening its monetary policy to rein in the inflationary risks.

Australia itself is growing strongly - although nowhere near the double digit rate of China, India and the other BRICs, Brazil and Russia. After a slower patch, retail sales seem again to be booming, sales of luxury cars are setting new records, jobs growth is still strong although slowing as overall GDP growth picks up (which is good news for productivity). Imports are growing but export volumes are also (finally!) showing signs of growth. The terms of trade - the price of exports relative to the price of imports - remain strong, perhaps still rising.

Australia’s mining companies large and small are expanding as fast as they can. Results will uniformly show large increases in revenue - at least for those companies already in production - but faster growth of costs. RIO’s results last week have set the example. These results were released along with a major ANU study that confidently predicted that the China boom would persist for many years yet.

Rowan Callick recently reported on this study: "Australia’s most influential economist, Ross Garnaut, [says] that China is at an historic economic and social turning point that will lead to an even bigger appetite for resources at higher prices.”

Garnaut himself was quoted directly as saying: "In 20 years time China is likely to consume more energy and metals than all of the industrialised economies today.”

Given the rush to expand output of energy and minerals to feed the China boom, it is historically unique that Australia has not generated a wage and cost explosion of enormously damaging proportions. The degree of labour market deregulation from the time of the Hawke-Keating government is the major reason for this unique outcome. The particularly helpful aspects in the recent past are the WorkChoices legislation of this government and its sensible use of 457 visas to allow a flood of skilled workers at manageable prices.

How long overall labour costs can remain contained is a vital question. Whether a Rudd Labor government can hold the line will be one of the key questions that economists and other economically literate voters will ponder as they prepare to vote in the coming Federal election.

Goods and service inflation was lower than expected in the December quarter 2006 and March quarter 2007. The latest inflation result was above expectations and even without wage pressure makes future inflation problematic.

Apart from inflation, the US “sub-prime” lending crisis is the major current cause for concern for the global economy. Its ripples are still spreading and in the past two weeks these ripples have produced a substantial equity market correction in most markets. Until Friday the correction in Australia’s market was around 8 per cent from the recent peak, but Wall Street’s ugly Friday trading is almost certain to increase the size of the correction at the start of this week.

Another bear point in the current global outlook is the price of oil, which has been steadily rising for some time now after the welcome drop in the lead up to the Northern summer. The upturn in the price of oil and of many other commodities is a clear manifestation of global inflation on the rise. Equity markets have become inured to the effects of dear oil, but more thoughtful investors have quietly factored inflation and the accompanying increase in global interest rates into their calculations.

As the graph suggests, corrections of 8 to 10 per cent are a feature of bull markets, and even before the current correction equity valuations were by no means as stretched as they became in the last surge of equity prices during the 1987 bull market. The current correction is most likely one we had to have in the midst of a bull market with a fair bit further to run.

Henry has spent this time on equity markets since market turmoil is a classic reason for central banks to avoid rate hikes even when the underlying economic story suggests the need for action.

The Reserve Bank has clearly prepped the market to expect the need for a rate hike this month. This is clear from the comments of “well informed” journalists, and most of the bank economists. “The Reserve hates surprises” one such guru said on weekend television.

Another tactical case for a rate hike this month - accepting that the strategic case has been clear for some time - is that it provides the greatest possible time before the Federal election.

RBA governor Glenn Stevens has made it clear he is quite capable of delivering a rate hike in an election year, unlike (according to those who check these matters) all of his predecessors. Still, hiking a month or so before the election is called might be seen as unduly aggressive, biting hard the hands that appointed him.

So on balance readers should expect a rate hike to be announced tomorrow. The main caveat is that two more very bad nights on Wall Street would provide a valid reason to wait and see. This is because two more very bad nights would begin to suggest the possibility of a major change of direction for global markets, well beyond the “correction in a bull market” currently on the cards.

Having waited in August, the balance would have to swing again to allow a September hike and by October the election would be announced - precluding any monetary policy change - or be so close as to effectively preclude such action.

The market has been “prepped”, the governor is no doubt prepped for action and biased against the tag of lacking ticker or consistency that might become his if he waits now and has to go later.

Expect a hike, and if there is no hike you will know that the Reserve is worried, perhaps very worried, about the global economy and its prospects.