Thursday, October 29, 2009

Interest Rate Rise Too Much Too Soon

With the release of yesterday’s inflation figures it seems that if you are looking for a dead certainty on Melbourne Cup Day it is that interest rates will go up. The only question is by how much. While the annual inflation rate remains low at 1.3%, that’s only part of the picture. The September quarter increase of 1% is a big chunk of that annual figure, and following on the previous quarterly results represents an alarmingly rapid upward trend. But further complicating the matter is the fact that the most significant price increases occurred with electricity, up 11.4%, water and sewerage, up 14.1%, and petrol, up 4%, which also flowed through to higher transport costs. Since utilities charges are largely determined by state government policy, and petrol prices by international markets, these price increases do not necessarily form an accurate reflection of local economic conditions. They are also not directly influenced by monetary policy, that is the interest rates determined by the Reserve Bank.

For this reason, when the Reserve Bank Board meets to consider interest rates, the most important measure of inflation will not be the headline rate, but instead the so called rate of underlying inflation. That rate is running at about 0.8% per quarter, or around 3.5% annually. That’s outside the Reserve Bank comfort zone of 2 to 3%, further adding to the case for an increase in interest rates. The third factor indicating an increase is the repeated advice form the Reserve bank Governor that the current low settings are at an emergency level, and that as the economic emergency eases interest rates must return to a more normal level. “Normal” means somewhere around 5%, which means there’s still 1.75 percentage points of interest rate rises ahead of us.

So what is the likely size of the increase to be decided next Tuesday? The broad consensus appears to be 25 basis points, although some observes are warning that we should not be surprised if the Bank opts for 50 points in the wake of the inflation figures. But while the inflation level is an important concern, it is not the only factor to be considered. The Treasury forecast for rising unemployment still stands, and the level of business investment is still fragile, and both of these indicators are vulnerable to increases to interest rates. Business borrowers in particular have for the most part not yet received the full benefit of previous interest rate falls, so any increase now is effectively a double whammy. The point is that while the economy has weathered the Global Financial Crisis better than expected, it is still fragile and vulnerable to any further adverse events.

The housing market is also presenting something of a conundrum at present with house prices rising strongly on the one hand, but actual sales falling. Combined with a lack of investment in new dwellings and of course the prospect of rising interest rates, this adds up to more problems with housing affordability. People who are looking for a house are less able to afford one, while people who have a house are enjoying an increase in the supposed value, but might find it difficult to actually find a buyer. It’s a situation which is not sustainable, and something has to give, but as long as there is a housing shortage the paradox will prevail, and when interest rates rise it will hurt both home buyers and home owners. The flow through will also impact on rental prices too.

On balance, an increase of 25 basis points next week might appear to be the safe option, but since much of the apparent inflation threat is driven by outside factors I suspect that even that much could be too much too soon.

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