The RBA came out today incredibly hawkish, forecasting that, based on market pricing for one rate hike by early 2012, and another rate hike by mid 2013 (ie, two more rate hikes), underlying inflation in Australia would still hit 3.0% by the end of this year, and a stonking 3.25% by end 2013. This has surprised the market, which did not believe the Bank would project above-target underlying CPI over its forecast horizon. And upside risks remain. The RBA assumed a high exchange rate (US$1.07) and trade-weighted index (TWI = 78) throughout its forecast horizon, when it knows that there is significant downside risk to both these variables and hence upside risk to inflation, particularly if US yields rise gradually over 2011-12. Just as importantly, the RBA assumed much higher than currently priced oil values, with Tapis crude at US$126 per barrel, which places downward pressure on global growth over the forecast horizon. Here are some quotes I just provided to Dow Jones:
"The RBA is set to hike 2-3 times in 2011. If unemployment holds steady at 4.9%, and wages growth remains healthy, the RBA is a very high probability to hike in June. The RBA knows it cannot rely on politicians or the currency to do its work for it. The RBA will consistently surprise the market with how early it moves. The message today is that both economists and the market, especially, have got the RBA decision-making framework wrong. Even assuming two more rate hikes and an elevated currency, the RBA is telling the market that core inflation is going to hit a stonking 3.25%. The RBA cannot afford to allow core inflation to overshoot its target again, as it did in 2007-08. It knows it got very lucky care of the GFC, and that there is no long-term trade-off between inflation and growth. It is crucial the RBA acts early to keep core inflation close to its 2.5% target, and it has mostly failed in this task over the last decade. Another 2-3 hikes this year is consistent with our central case for the housing market, which projects little to no house price growth with the risk of some modest nominal declines. This is, however, good news: it will only improve housing valuations, and is entirely consistent with what the RBA wants to achieve. The housing market going sideways for an extended period looks exceptionally good in comparison to the 50% hair-cut experienced by the Aussie sharemarket during the GFC."
