A very good note from Chief Economist Michael Blythe:
"The interest debate has shifted significantly in the last few weeks. Markets are now pricing in rate cuts and one forecasting house has shifted its call from rates up to rates down. Markets have flirted with the possibility of rate cuts from time to time over the past two years. But the consensus amongst economist has unanimously backed a rates‑up view since mid 2009.
The shift reflects the intensification of European sovereign debt concerns, some disappointing US economic data. A cautious consumer and the restraining influence of the high AUD.
Our views on these issues have been set out elsewhere. From a policy perspective these issues may affect the timing of the next rate move but are unlikely to change the (upward) direction. The direction of rates should reflect views on the medium‑term outlook. Over that horizon the fully‑employed economy will need to digest the substantial income flow and business capex flowing from Mining Boom Mk II. The resultant inflation risks and resource allocation issues point to higher rates.
Much of the rates debate reflects offshore developments. US economic weakness and European sovereign debt issues are symptomatic of recoveries after financial crises. These upturns are typically weaker and more drawn out than usual. We shouldn’t be surprised when they proceed in fits and starts. Or when weaknesses exposed by the preceding crisis prove enduring. Interestingly, the ECB lifted rates despite what is happening in Europe whereas Australian markets want to price rate cuts because of what is happening in Europe.
How the European story plays out is a judgement call. If you believe that what is happening is the precursor to GFC Mk II then you will come to different conclusions about the direction of the economy and interest rates than if you don’t. A European financial collapse in not in our baseline forecasts. Partly because the European story is by no means uniform. That story has fractured into three parts. Genuine weakness is evident in the peripheral economies such as Greece and Ireland. Genuine strength is apparent in the core economies of Germany and France. Another group, Italy and Spain, lie somewhere between. We expect the larger, stronger economies to dominate.
The resolution of sovereign debt issues will be a lengthy process. IMF simulations of how long it would take to stabilise advanced economy gross debt at 60% of GDP (the pre‑crisis median) stretch out to 2030. Markets operate on a different timeframe and are unlikely to have the stomach or patience for a 10‑20 year adjustment program. Financial market volatility is likely to be an enduring feature of the economic landscape.
On paper at least a number of countries have laid out plans that imply they are well advanced in meeting the necessary adjustment goals. Portugal, for example, has in place 88% of the necessary measures to meet 2016 targets for debt stabilisation. Market pricing makes little if any allowance for this progress.
The IMF has modelled the impact on the rest of the world of Eurozone turbulence that severely disrupts global financial markets. From a growth perspective, the modelling shows that the region least affected in emerging Asia and the country best placed is Australia. Australia fares relatively less worse because of our linkages to the Asian story and because our policy makers have an ability to respond.
The case for higher Australian interest rates over time is still there. And in normal times the QII CPI data due on 27 July would probably have been enough to produce some policy action. Our preliminary forecasts, for example, would imply that underlying inflation was running at an annualised rate of 3¼% in HI 2011. That outcome would be conclusive evidence that the inflation trajectory had turned up. And that the top end of the RBA’s target range was under threat.
But these are not normal times. The RBA’s approach is likely to be a little more cautious. We have pushed our August call back to November."
