Reversing the Emergency Setting

Australia's economy stared down recession and was the only developed nation to grow in the first half of 2009 despite the global economic downturn with the help of massive counter-cyclical macroeconomic stimulus. The Reserve Bank of Australia (RBA) slashed its leading interest rate, initially to alleviate severe liquidity constraints and then, as the risk profile shifted to the real economy, to boost demand. At the start of the rate-cutting cycle the official cash rate (OCR) stood at 7.25%, then between September 2008 and April 2009, the OCR was reduced 425 basis points to the 49-year low of 3.00%. Monetary policy was then supported by an aggressively expansionary fiscal stance implementing two major stimulus packages worth a cumulative A$50 billion (US$41.2 billion), and an expansionary fiscal year (FY) 2009/10 budget.

The combination of monetary and fiscal stimulus fuelled private consumption and business investment and allowed the Australian economy to grow by 0.6% quarter-on-quarter in the three months to June. Beyond macroeconomic stimulus, growth has also been driven by continued strong demand from China for commodities exports such as coal and iron ore. Following a string of better-than-expected data releases the RBA moved to a neutral policy bias at its August meeting. Market expectations were that the RBA would move to a tightening bias following another string of good news in recent weeks, but markets were only pricing in a 50% chance of an October rate hike before yesterday's announcement.

Risk Profile Shifts from Growth…

Glenn Stevens, governor of the Reserve Bank of Australia, justified the move to a tightening bias on the grounds that economic conditions have been "stronger than expected", with Australia faring better than many of the major economies because "prospects for Australia's Asian trading partners appear to be noticeably better." Data releases in recent weeks have continued to their string of better-than-expected results. Confidence indicators are at multi-year highs, which will help fuel growth going forward. Leading indicators for the manufacturing sector are also indicating growth in the coming months, especially as inventory restocking is needed after the vicious inventory slashing cycle of recent quarters. Retail sales also grew during August after falling the previous two months, as the effects of fiscal disbursals from the government waned, implying that household demand is recovering. Also of note was that credit to the private sector rose for the first time in eleven months during the month of August, rising by 0.1% month-on-month led by a 0.6% increase in housing credit and a 0.5% increase in other personal credit. Nevertheless, some risks to growth remain. The RBA acknowledged in its statement that consumer demand and business investment are still likely to soften in coming months but the outlook appears less grim than previous assessments.

…To Rising Inflation and Asset Price Risks

With the positive data releases stacking up and indicating faster growth than originally anticipated, the central bank has become more concerned about the country's inflation outlook rather than the growth outlook. Headline inflation came in at a ten-year low of 1.5% year-on year in the second quarter of 2009 owing to lower commodity prices. However, the RBA aims for a core or underlying inflation rate of 2-3%, and in the second quarter underlying inflation came in at 3.9% year-on-year. Capacity utilisation dropped sharply in the first half of 2009 as part of the inventory rundown helping to lower inflation. If economic activity expands at a faster-than-anticipated rate though then capacity constraints could add to inflationary pressures in the near-to-medium term. The producer price index continued to decline in the second quarter which should have resulted in lower core price pressures during the third quarter, yet it is possible that underlying inflation still did not fall into the RBA's target zone owing to the higher-than-anticipated level of economic activity in recent months. In the statement accompanying the rate change, Stevens stated that "underlying inflation should continue to moderate in the near term, but now will probably not fall as far as earlier thought."

The housing market in Australia has also performed extremely well in the first half of 2009, which has sparked concerns about an asset price bubble. In the three months to June, the index for average house price in the eight Australian state capitals rose by 4.2% quarter-on-quarter, but were down about 1.4% year-on-year, which is a negligible change considering the corrections seen in other advanced economies. House prices were largely supported by the government's first-time home-buyer tax credits as such credit to that sector has performed well in recent months. Higher prices have also arisen from recent financial market turmoil as well as regulatory issues such as land zoning and development and building approvals process according to Tony Richards the RBA's Head of the Economic Analysis Department. Moving forward, house price increases should moderate as the first-time homebuyer tax credit will be reduced from October 2009. Following the RBA's leading interest rate announcement, the four top banks in Australia placed their standard variable home-loan mortgage rates under review which will reduce housing affordability and demand.

Outlook and Implications

IHS Global Insight expects that since the RBA has moved to a tightening bias, it will continue its monetary tightening cycle with a series of incremental rate hikes likely in the coming months. We now anticipate the official cash rate to reach around 4% in early 2010. From there the RBA will pause to take stock of the economic conditions including inflation and asset price risks, before instigating another round of measured hikes as the bank will aim to push interest rates to a more neutral level, which is commonly viewed as being around 5-6%. Fiscal stimulus will continue to feed into economic growth through the rest of the year, and Treasury Secretary Wayne Swan has stated that there will be a gradual withdrawal of the stimulus starting in the fourth quarter as envisioned in the budget.

Australia is not technically the first developed economy to lift its rates in this cycle—Israel acted in August—but this is a much more influential decision. It will be studied closely not only in other G20 countries, but also more widely across Asia where rate increases are a growing possibility. Elsewhere in the G20 policy makers have been playing down the likelihood of early moves given the generally slow pace of recovery.

Global Insight (Reino Unido)