25 Jul HEADS OR TAILS? – The Great Aussie Two Up

What are the factors influencing the movement of interest rates in Australia for the next 6 months?  How does the international economy play a role in this?  For an informative discussion on the issue, please read Andrew’s article below or click on the LINK at the bottom of the page to read the PDF.

We welcome any comments and discussion about the article.

Which way now for Australian interest rates?

This week the RBA released the minutes from the latest Monetary Policy Committee meeting which saw interest rates left unchanged at 2.75%. Forecasting which way interest rates are heading is a difficult game but here are the reasons why I think rates are heading lower by end year.

1. Growth will continue to edge lower this year with significant risks to the    RBA growth outlook in 2014 and 2015 as large scale mining investment ebbs way, and the investment hole is unable to be met quickly by other sectors of the economy. Unemployment is set to rise on the back of weakening economic growth and employment gains.
2. Core inflation will remain low and allow for further easing scope – there will be some rise in imported inflation (mostly via energy transfers) but businesses will chose to compress profit margins to maintain demand rather than hike prices to consumers in already difficult times.
3.  International pressures will remain intense, particularly in China where the new leadership seems keen to tackle the rebalancing issue early on in its reign. Demand for Australian commodities will weaken in the rebalancing and the prices paid for those commodities will continue to be soft.
4. Japanese and other Asian demand looks also set to weaken with the risk of Asia following the US and EU into recession rising. Will parts of Asia face the same debt problems that other regions have faced already?
5. Fiscal policy will need to tighten over the coming years as weakening tax receipts pushes up deficits and debt.
6. Although the exchange rate is set to fall further, parallel interest rate cuts will be needed to continue to buoy private consumption and keep house prices elevated (despite this increasing house price bubble risks further).

The baseline scenario is dovish with further policy responses now limited. Despite the minutes focussing on the weaker than expected growth and inflationary conditions with downside risks, the markets chose for the moment to focus on the new emphasis placed on the falling exchange rate which could be seen to be doing the job of further rate cuts.

It is clear that markets are uncertain which way interest rates are heading – with the heavy international uncertainty now being outweighed by domestic activity risks. In fact only one thing is certain in the phase ahead – more uncertainty!

The markets have been continually wrong at calling the low in the current interest rate cycle, and looking at the challenges ahead that poor forecasting trend is set to continue. The great news is that falling (variable) rates equates to a cheaper cost of capital equation for businesses.

Andrew Stockman

Economist