It’s the vibe

01 December 2010

The minutes from the Reserve Bank of Australia's (RBA) November monetary policy meeting provided a valuable insight into the thinking of Australian policymakers and what this means for the interest rate outlook in 2011.

In the iconic Australian film, 'The Castle', one of the characters justified his actions with the now famous phrase: 'it's the vibe'.  And, the Reserve Bank's decision to raise the cash rate in November could be viewed in this light

That is, despite a raft of very convincing arguments put forward for leaving interest rates steady in the month - relatively modest Q3 inflation, subdued credit growth and house prices, a sharp appreciation in the A$ and uncertainty surrounding the impact of US Federal Reserve policy decisions - policymakers still deemed that a "modest tightening of monetary policy was prudent".

This was based on expectations that the Reserve Bank's central scenario was still likely to unfold due to increased certainty on the outlook for China, ongoing strength in commodity markets - even though the RBA index of commodity prices actually fell between October and November - and a firm outlook for business investment, stoked by a booming terms of trade.  Put simply, policymakers were more confident in the economic outlook.

So, what should markets take away from this statement? A simplistic reading of these minutes suggests little reason for the Reserve Bank to continue raising rates in early 2011.  The strength of the A$ is helping to contain inflationary pressures and the larger increase in mortgage rates has already provided an effective additional tightening on household balance sheets.

At the same time, the RBA doesn't seem too concerned about growth, noting that the acceleration in GDP will only be "gradual" and that "the labour market may not be as tight as indicated by the unemployment rate".  

But in this instance we think that actions speak louder than words.

That is, despite a clear argument for leaving rates unchanged in November, the Board still decided to tighten based on forecasts for strong GDP growth and inflation in 2011-12.  And, so long as businesses continue to show robust investment intentions, the RBA's central scenario will remain on track.

In our view, only a sharp fall in commodity prices, a major downgrade to investment intentions or a sustained rise in the unemployment rate would see interest rates stabilise.  Absent these developments, the RBA could hike interest rates whenever it feels 'the vibe' again.

It is also important to note that with standard variable mortgage rates rising by an average of 40bps since the cash rate announcement, it appears that the tightening was a little more aggressive than the "modest" adjustment that policymakers may have intended.  That said, the minutes reveal that members were aware that lending rates would likely increase by more than the increase in the cash rate, and that the Board would "take account of changes in margins in its decisions in the period ahead".

Economic update brought to you by Macquarie Research