THE WEEK AHEAD: All eyes on the RBA

If you were surprised at the timing of the rate hike, you were not alone. Even the Reserve Bank Governor was caught on the hop. It all has to do with the latest economic growth forecasts from Reserve Bank research staff.

In testimony to the Senate Economics committee on September 28 – eight days before the Reserve Bank Board meeting – Governor Stevens indicated that stimulus would need to be “withdrawn in a timely fashion as the recovery proceeds”. But he carefully noted: “not too soon, because we do not want to abort the recovery but not too late either, because we do not want to overheat it”.

When asked whether the outlook for the economy was more pleasing than at the time of his testimony to the House of Representatives committee in late August, Glenn Stevens said that he was waiting on new economic forecasts to be published at the next Board meeting.

Those new economic forecasts were prepared over the next few days and included in the papers sent to Board members on the Friday ahead of the Board meeting, as is the usual custom. The forecasts were dramatically upgraded; indicating that growth over 2010 was more likely to be 3¼% (near trend or normal growth) rather than 2¼%. As a consequence inflation was also expected to higher than expected. The bottom line is that these forecasts were inconsistent with cash rates at 3%. The rate hike cycle had to begin.

On the Friday ahead of the Board meeting Reuters conducted its usual interest rate poll of economists. Only two of the 20 economists tipped a rate hike for the following Tuesday. And financial market pricing put the chance of a rate hike at only 20%. If rates were to rise on Tuesday financial markets and the general community would be taken by surprise, something of a concern to Reserve Bank officials.

On Monday a number of senior newspaper economic commentators warned that a rate hike could occur the following day. The warning was promptly heeded by financial markets with the chance of an October rate hike soaring to 60%.

The rest, as they say in the classics, is history. The Reserve Bank lifted rates by 25 basis points and explained its reasoning in an unusually long eight paragraph statement. The new economic forecasts were given prominence in the statement with economic growth forecasts mentioned twice together with two references to inflation, now expected to be close to the target.

The Reserve Bank’s models aren’t foolproof. But they have guided decision making successfully over the years. In the end, judgement is also required. All the indicators suggested that the rate hike cycle should begin, so it was deemed that there was little point in holding off for another month.

The week ahead

The coming week is unlikely to prove as exciting as the last – no rabbits out of the hat! But the Reserve Bank Governor does get a chance to explain the latest rate hike. And there is a fair spattering of economic data to set the scene for the next Reserve Bank Board meeting.

Reserve Bank Governor Glenn Stevens doesn’t deliver his speech until Thursday. But it will certainly be keenly awaited. Did he know that rates needed to rise at the time he gave testimony to the Senate economics committee? What does he mean by: “gradual lessening the stimulus provided by monetary policy”? And is he able to outline the details of the latest economic forecasts that were so dramatically upgraded in the past week.

In terms of economic data, lending finance figures kick off the week on Monday. And Federal Treasurer Wayne Swan delivers a speech on the same day.

On Tuesday the NAB business survey is released with consumer sentiment on Wednesday and the Reserve Bank Bulletin on Thursday.

The Reserve Bank is more upbeat about the current recovery, but for its confidence to be validated, lending will need to show signs of improvement. The August lending data is released on Monday and analysts will especially be looking for signs of a pick-up in business lending.

Both business confidence and conditions are expected to consolidate on recent gains when the NAB survey is released on Tuesday. But there is less surety about the October consumer confidence reading. While it is a sign of strength that the Reserve Bank is lifting rates, for consumers, higher rates are generally viewed negatively. And Thursday’s Reserve Bank Bulletin is likely to show more signs of consumer conservatism with debit cards still in favour for making purchases over credit cards.

In the US, retail sales figures are released on Wednesday together with minutes of the last Federal Reserve meeting on September 23. Consumer price data is issued on Thursday and industrial production and consumer sentiment figures are released on Friday.

The data on inflation or consumer prices shouldn’t trouble investors. We expect that the core measure (excludes food and energy) edged 0.1% higher in September to stand 1.5% higher than a year ago. But the main interest will be in the retail spending and production figures.

Overall we expect modest readings for both indicators with both non-auto retail sales and production likely to have lifted 0.2% in September. But consumer sentiment should prove more positive, underpinned by a firmer sharemarket and modest gains in house prices. We expect that consumer sentiment lifted from 73.5 to 76.0 in October.

Sharemarket

The US profit-reporting season has begun. And while it won’t reach its peak for another fortnight, the season will certainly crank up a notch in the coming week. In fact, the earnings season (and, in turn, the bull market underway across global sharemarkets) will face a major litmus test with four major financial institutions among those to issue results.

Among the companies reporting in the coming week are Intel and Johnson & Johnson, both with earnings slated for Tuesday. On Wednesday JP Morgan Chase is scheduled to report with Advanced Micro Devices, IBM, Goldman Sachs and Citigroup slated for Thursday. Bank of America and General Electric will issue earnings results on Friday.

Interest rates

The Reserve Bank has begun the process of returning rate settings to ‘normal’. The key question is how quickly the goal will be achieved. As the Reserve Bank Governor has noted, the aim is to lift rates gradually so not as to threaten the recovery, but not too slowly to cause the economy to overheat.

CommSec expects the Reserve Bank to lift rates in November. Then we expect the Reserve Bank to pause until the New Year, before lifting rates in February and March. At least four further rate hikes are expected from May. Overall we expect the cash rate to be around 4.50-5.00% in twelve months time. While the Reserve Bank has indicated in the past that a ‘normal’ or neutral cash rate is around 5.25%, an Australian dollar trading close to parity with the greenback suggests that the Reserve Bank will be aiming for a lower target.

Currencies & commodities

The Australian dollar could be headed for parity against the greenback. Our currency strategists have lifted their forecasts for the Australian dollar, driven in large part by the strong performance of the Australian economy and early start to the rate hike cycle. The Aussie dollar is now expected to lift to US93 cents by end year and US98 cents by June 2010.

Apart from the strength of the Australian economy, the on-going recovery of the global economy (driven by China) will lift commodity demand and prices. And the stronger commodity prices will translate to a firmer Aussie dollar. At the same time the US economic recovery is likely to be prolonged, due especially to the weak job market. As a result, the US dollar is expected to remain out of favour with investors, giving a further leg up to the Aussie.

Craig James is chief economist at CommSec.