Reasons why RBA should not start tightening before February next year

As expected the RBA kept rates steady following the September Board meeting. The Governor’s Statement was broadly similar to the August with the exception of a more bullish outlook for business investment. In August it was described as "increasing" whereas in September it is described as "could increase strongly". As discussed previously, that increased optimism would have stemmed mainly from the CAPEX survey which saw investment intentions for 2010-11 marked up from a 20% rise in the Q1 estimate to a 30% increase in Q2, the third estimate for the 2010-11 financial year. CAPEX only covers about half the investment measured in GDP and is in nominal terms rather than real terms so the slippage can be significant. However we have sufficient faith in that third estimate to raise our business investment profile for 2010/11 to an increase of 15% – the flow on has been a boost to our GDP growth forecast in 2011 from 3.5% to 4%.

The other significant change in the Governor’s Statement was the reference to policy being appropriate "for the time being". That term was not used in the Governor’s statement in August but was used in the August Board Minutes so is probably not as significant as might at first seem.

However, markets received a jolt from the August jobs report which printed a fall in the unemployment rate to 5.1% from 5.3% (back to the level in June) and 53,000 new full–time jobs partially offset by 31,000 loss in part time jobs.

After weeks of haranguing the markets for their persistently unrealistic pricing that the next move in rates would be down we now find that they have turned around and are predicting a rate hike by December with a probability of around 50%. That probability increases to 100% by April next year but stops with only one move priced in.

We don’t expect the move to be quite so soon and expect that there will be a sequence of three rate hikes through 2011.

That 50% probability was franked by an informal survey of 200 corporate and institutional customers who attended our annual Conference on September 9. Some 49% of respondents expect another rate hike in 2010; 46% expect the first move in the first half of 2011; and a lonely 5% expect that the next move will be down.

We have been comfortable arguing the "rate increase" case. Arguing that the timing will be later than market expectations is more difficult. We think that the areas of the economy which will be giving the Bank the greatest reason for caution are around the consumer and housing – the two most interest sensitive parts of the economy.

It was interesting that the Governor chose to exclude reference to the consumer (55% of expenditure) in his September statement. In the August statement he referred to households: "displaying a degree of caution". There was no reference to households in the September statement probably because consumption spending grew by a stunning 1.6% in the June quarter national accounts. However he was not prepared to speculate that the "degree of caution" had eased significantly. Our view is that there will be a considerable easing in this "caution" through 2010 as long as rates remain on hold.

While the Westpac Consumer Sentiment Index has returned to pre-crisis levels its strength is mainly reflecting extraordinary optimism

in how households see the overall economy – very positively but possibly mainly because of the mining boom which households perceive as not improving their own position. That is borne out when we consider those components of the Index that relate to households’ own financial position and spending intentions (see chart). These have seen a more restrained recovery, weighed on by rate hikes, and has only recently pushed significantly above average. With another month of steady rates we expect that component to increase further in September even if the overall Index is flat and the "economic outlook" components retreat a little. We will get a read of the September result on September 15 .

It is our view that these components of the Index are fragile and any imminent rate move would risk a sharp retraction in the consumer before it gets a chance to build momentum. We suspect the Bank is similarly concerned particularly if it is hearing from its liaison staff the same "stories" that we get from our customers in retail and those customers who service discretionary spending.

Another argument for waiting revolves around the global economy. Prospects for the US economy are dim. Our forecast for GDP growth in the US in the second half of 2010 is 0.7% (annualised) with growth in 2011 of 1.5%. When we surveyed our customers (see above) on the outlook for US growth in 2011, 70% of the sample expected it to be below 2% in 2011 – well below the Consensus forecast of 3.1%.

Of course, the timing of the next rate move will also be affected by the September quarter CPI which will print on October 27. We argued that a 0.8% or above print for the June quarter would have given the Bank little choice but to hike because it would have been required to raise its annual inflation forecasts for 2010 and 2011 from 2.75% to 3%. A print of, say, 0.8% for the September quarter would leave inflation for the first three quarters at 2.1% – it would be credible for the Bank to argue that a 0.7% was possible in the December quarter thus not necessitating a rate hike on the basis of inflation. Prospects for the next CPI are much closer to that 0.8% than the 0.5% we saw in the June quarter. We do not expect the falls in components of the CPI such as domestic and offshore holidays; food; and deposit and loan facilities which drove the extraordinarily low June quarter CPI to be repeated in September but the Bank has much more flexibility with the next CPI than it had with the June quarter measure.

Bill Evans, Chief Economist Westpac Banking Corporation

Consumer sentiment decomposed

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