November 7. As virtually everyone expected, the Reserve Bank of Australia lifted its cash rate target 25bp to an eleven-year high of 6.75% in response to the worse than expected underlying inflation results for the September quarter. The move was the first to occur during an election campaign and may cause some further damage to Prime Minister Howard's bid for a fifth term in government, particularly given his promise at the last election in 2004 to keep interest rates at record lows. Since then, interest rates have risen six times and today's move looks unlikely to be the last given a robust economy, tightening labour market, relatively loose fiscal policy and of course rising food and energy prices that should probably have been met with policy tightening earlier in the game.
The central bank explained its move as a response to the stronger pace of economic growth this year and few signs of that slowing. It said that growth in aggregate demand will "need to moderate if inflation is to be kept to 2-3 per cent in the medium term." It also mentioned that both headline and underlying inflation measures are likely to be above 3% by the March quarter (IFR thinks by December, see below). The RBA also noted that so far funding costs in Australia had not been overly pressured by global credit pressures. More will become clear in next Monday's quarterly Statement on Monetary Policy that will contain the central bank's projections for interest rates, inflation and economic growth. Speculation that it might lift its forecast for underlying inflation to 3.25-3.50% in the Statement would suggest that it finds itself behind the ball in policy and would raise the risk of another move as soon as December.
Now thoughts will turn to the RBA's next move. Given the underlying tenor of the economy and the upside risks to inflation from wages and prices, exacerbated by hefty public- and private-sector investment intentions, IFR expects the two moves so far this year to be far from the last. Indeed, a year from now IFR expects the cash rate to be fully 75bp higher at 7.50%, again with the risks largely to the upside. Rising food and energy prices should be enough to justify another move in December without confirmation from the CPI report in January; a hawkish Statement next week would lift expectations of such a move. Barring that, another rate hike looks odds-on in February, as the December quarter inflation result will definitely see headline inflation jump above 3% with underlying inflation close behind. But there are also dangers from the perception that the central bank is taking a reactive approach to policy setting, namely that inflation will get out of hand as the RBA focuses on the recent past. The situtation would be rather better today had the central bank moved pre-emptively last February as was widely expected at the time--and might have helped avoid the need for a controversial move during the election campaign.
About the only serious clouds on the horizon are the continued sub-prime problem that may push the US into recession, and the strength of the AUD as a result of the slumping dollar. The sub-prime problem may keep upward pressure on interbank rates, thus mitigating the need for a policy rate hike (though this might still be necessary to prevent a take-off in inflationary expectations that are unlikely to be too affected by moves in a market that most do not understand). Demand for Australia's commodities should remain strong with no sign that the major economies in this region (apart from an already weak Japan) will slow by much even if the US suffers a period of consolidation. Moreover, the strong dollar will help insulate Australia to some degree from the surge in oil prices, though this will be more than offset by the drought-induced jump in food prices expected over the next several months. There seems little at this point beyond a global financial meltdown or recession that will prevent further steady tightening in Australia's monetary policy.