RBS's Kieran Davies and Felicity Emmett are two of the best in the business...
"On Tuesday, the Reserve Bank Board left the cash rate unchanged at 4¾% for the fifth meeting in a row, although it signalled that it was now leaning to higher interest rates with a change in language. That is, after the Bank had described monetary policy as "appropriate" for several months in a row, it added the qualification "in future meetings, the Board will continue to assess carefully the evolving outlook for growth and inflation".
While this was more hawkish language, it was not as significant shift as we had anticipated (we had looked for a shift to "appropriate for the time being", in the same vein as the shift made in the months leading up to last November's rate rise).
Subsequently, however, there was a rash of newspaper commentary suggesting that the market has misread the Reserve Bank's comments and that the Bank was actually more hawkish than the market had thought. Indeed, some commentary suggested that the Bank would raise its inflation forecasts to more than 3% in today's Statement on Monetary Policy.
While we had thought that the Bank would raise its inflation profile to have 3% by the end of 2011, followed by 3% in 2012 and 2013, they have made the 2011 change and actually raised the 2013 estimate to 3¼ %, above the 2-3% target band (they also reduced the forecast low in unemployment in 2013 from 4½ to 4¼%).
Our own forecast profile has inflation breaching the target band, which is why we have an aggressive forecast peak of 6% for the cash rate, but we never expected the Bank to publish a number outside the target band, as previously they had only ever done this when inflation had already exceeded their forecast and they were subsequently forecasting inflation to return to the band.
This extremely hawkish change was reinforced by the last paragraph of the main section of the statement, which said, "Since November last year, the Board has held the cash rate steady at 4.75 per cent. With interest rates on most loans a little above average, this represents a mildly restrictive stance of monetary policy, which the Board has viewed as appropriate over this period given the general outlook facing the Australian economy. Consistent with the Board's long-standing approach, it will continue to focus on the medium term in setting monetary policy and look through the volatility in inflation and economic activity as a result of the natural disasters during the summer. The central outlook sketched above suggests that further tightening of monetary policy is likely to be required at some point for inflation to remain consistent with the 2-3 per cent medium-term target. In the challenging economic environment that is likely to lie ahead, the Board will set policy to ensure a continuation of the low and stable inflation that has made an important contribution to Australia's strong economic performance over the past two decades."
In early March, a slower-than-expected decline in the unemployment rate had seen us shift our forecast resumption of rate rises from May to August, but today's statement indicates that June is a likely option, notwithstanding something out of left-field (a likely contraction in Q1 GDP no longer qualifies as a shock as the Bank now factoring in a decline).
The timing of a cash rate rise often involves judgment, but if this proves right, we still expect rates to go much higher as a solitary rate rise is unlikely to bring inflation back inside the target band, a point indirectly made by the Bank when it noted that its inflation forecast was based on the technical assumption that the cash rate moved broadly in line then market pricing, which was for a peak in the cash rate of 5%.
While this week has left us a little surprised why the Bank wasn't blunter in Tuesday's statement, the clear message is that the Bank is again indirectly signalling the market via the media. This longstanding practice of the Bank (and other central banks for that matter) had looked like it had been ditched last year, although we wondered at the time whether this was a permanent change.
For market pricing, the odds of a June move now stand at 37%, building to 52% in July and 79% in August. The market's forecast peak in rates is now about 5¼%, reached in Q3 next year."
