Australia | May 29 2007
By Chris Shaw
For some time the Reserve Bank of Australia (RBA) board has made it clear its policy decisions with respect to interest rates are data driven, with inflation the current main point of focus.
This has meant the pressure has come off the bank in the past couple of months in terms of being forced to lift rates further, as the recent inflationary data has shown the core rate of inflation has moderated of late.
But as Westpac Bank senior economist Justin Smirk points out this should not be confused by the market as a sign official interest rates are more likely to move down in coming months, as it suggests the RBA is now in something of a conundrum given the strength in the economy is suggestive of upside risks for the inflation rate.
This leads the bank to go back to its model for interest rates, which factors in not only the RBA’s target range for inflation but also the real factors present in the economy. And with these real factors still very strong the bank suggests only a minor uptick in inflation could be enough to force the RBA to pull the rate lever and lift interest rates further.
To understand the bank’s model requires an understanding of its elements, which include a neutral real interest rate, inflation expectations, an indicator of the strength of labour markets and domestic demand and any variations in core inflation away from the RBA’s target.
While each factor impacts, the most important is inflation as by getting this forecast correct the bank’s model is relatively accurate in predicting the level of interest rates. As an example the bank notes its model shows a median forecast for interest rates of 6.44% for the current quarter, which is above the official cash rate and so suggestive of the RBA holding a tightening bias, which is indeed the case.
This means rates are more likely to move higher than come down in the short-term, though by extending it out to the end of the year implies an interest rate of around 6.0%, supporting its view the pressure is off the RBA in the short-term.
Extending into 2008 though shows the model incorporating a re-acceleration of core inflation, which when combined with a multi-decade low in the unemployment rate and some early signs the housing sector is picking up implies rates are set to go higher next year.
This is indeed the bank’s view, as it is forecasting a further two hikes in official rates by early next year, which would put the cash rate at 6.75%.