Higher Rates Still On Agenda: Rba

The Age

Wednesday May 7, 2008

Scott Murdoch

Reduced demand may stave off another rate rise but blow-outs in goods and services prices and wages remain key risks.

THE Reserve Bank has warned Australians that the risk of higher interest rates remains, if economic growth and the elevated inflation rate do not come back under control.

RBA governor Glenn Stevens said the bank believed inflation should slow as the economy's demand growth moderated, but it did not sound entirely convinced this would be the case given the likely windfall from the persistent commodities cycle.

His statement was tougher than in April when he indicated the Reserve Bank could have finished raising interest rates.

"In the short term, inflation is likely to remain relatively high, but it should decline over time provided demand evolves as expected," Stevens said.

"Should demand not slow as expected or should expectations of high ongoing inflation begin to affect wage and price setting, that outlook would need to be reviewed."

The rhetoric from the RBA shows that the risks to inflation, and interest rates are still firmly to the upside. The most robust observation is that the RBA is ready to raise rates, and that an interest rate cut before the end of the year is off the agenda.

The bank highlighted strongly that given the recent price increases of up to 300% in coal and iron ore contracts, the benefits of the boom would further add to the potential of the nation to spend. This month the bank admitted the rise in trade was going to be larger than expected.

"It will add substantially to national income and ability to spend, even with the slowing in global growth to below trend pace that the bank has been assuming for some months now," Stevens said.

This is a significant addition for the RBA. It shows that, at a time when the bank wants spending and demand to moderate, there is a clear risk that spending could be spurred on by the boom and put more fuel on to the inflation flames.

It is also a contradiction to recent campaigning by Labor. Emphasising that a "home brand" budget will be delivered on Tuesday, the Government has been active in playing down the potential revenue spike from resources. The revenue still comes onto the national bottom line and allows the surplus to firmly exceed the 1.5% gross domestic product target or provide the funding for positive budget surprises.

But the switch in sentiment from the central bank that it still has a tightening bias has made the tone in which Treasurer Wayne Swan's first budget will be judged - and then reacted to - even tougher.

The $31 billion worth of tax cuts coming the way of workers from July, at least in the short term, should not endanger inflation too greatly given the tight financial conditions that consumers are facing.

The risk is that the Government stokes the economic fire too much. That is is unlikely from direct measures, but potentially from indirect measures. The discussion of spending cuts has been endless and the tight budget message strongly pushed. But Labor has to have a first-term goodie up its sleeve. The Government has ruled out more changes to the tax rates on top of the July 1 changes, so extra tax reform and potential tax savings will have to come in the form of tinkering around the edges.

The test for economic policymakers is to ensure wage inflation breakouts do not occur. The Victorian decision to award teachers a hefty pay increase was identified by Kieran Davies, from ABN Amro, as a concern, given it could influence other state deals.

While wages have been under control for the past few years, when unemployment was consistently edging down, economists believe wages are the greatest threat to higher rates. As Swan has argued that Labor's tax policy is based on productivity, the Government cannot risk any measures that lead to higher wages and interest rates.

STATEMENT BY GLENN STEVENS, GOVERNOR

At its meeting today, the board decided to leave the cash rate unchanged at 7.25% .

Inflation in Australia has been high over the past year, with the CPI rising by a little over 4% and underlying measures at a similar pace. Price rises were widespread, in an environment of limited capacity and earlier strong growth in demand.

In order to reduce inflation over time, growth in aggregate demand needs to be significantly slower than it was in 2007. Evidence is accumulating that this is occurring.

Indicators of household spending have recorded subdued outcomes over recent months, and demand for credit by both households and businesses has weakened.

As a result of the board's earlier decisions, additional rises in market interest rates and tougher credit standards for some borrowers, there has been a substantial tightening in financial conditions since the middle of last year.

Conditions in international financial markets, though improved in recent weeks, also remain difficult. These factors are acting to restrain demand.

The rise in Australia's terms of trade currently occurring, which is larger than had been expected a couple of months ago, will work in the opposite direction. It will add substantially to national income and ability to spend, even with the slowing in global growth to below trend pace that the bank has been assuming for some months now.

Given the opposing forces at work, considerable uncertainty remains about the outlook for demand and inflation.

On balance, the board's current assessment is that demand growth will remain moderate this year. In the short term, inflation is likely to remain relatively high, but it should decline over time provided demand evolves as expected. Should demand not slow as expected or should expectations of high ongoing inflation begin to affect wage and price settings, that outlook would need to be reviewed.

Weighing up the available domestic and international information, the board's judgement is that the current stance of monetary policy remains appropriate for the time being. The board will continue to evaluate prospects for economic activity and inflation in the light of new information. www.rba.gov.au