Interest Rates: What Next?

Interest Rates: What Next?

By: Fat Prophets

Unless there's a rise in unemployment and a definite slowing in domestic economic activity from the current 5% a year plus growth in non-farm domestic product, further rate hikes will almost certainly be delivered by the Reserve Bank next year.

And the only way to avoid a series of rate hikes is for the incoming government to prune its spending programs to reduce further over-stimulating the economy.

This will be the immediate priority for the new government after November 24. Standby for a lot of 'non-core promises' to emerge and if the ALP wins, for a budget black hole or three to be discovered.

Both sides have promised over $40 billion in tax cuts and spending packages: probably upwards of $50 billion each, taking the figures at face value and assuming no double counting.

That's over the next four years or so but would on top of the strong level of demand coming from the resurgence in business investment which remains the biggest positive we have going at the moment. At least the surging domestic demand is not coming from a housing bubble or a consumption binge by households.

It's not that the economy is going to hell in a hand basket, far from it.

Its just that we are growing too fast for our own good and that too much coal is being shovelled onto the fire by way of record terms of trade, solid wages growth, tight employment conditions, tax cuts from the last budget and the positive impact of the higher Australian dollar which is encouraging demand for consumer goods (imports) through price cutting.

The Australian economy is now 17 years into the current expansion and the RBA feels now it needs to tighten the throttle significantly: the bank now feels it should have tightened back in April but was fooled by two quarters of understated prices growth which are now well and truly out of the equation.

Whoever wins the November 24 election will face a straitjacket of up to two years of tight rates and not much leeway for going mad with the spending proposals, even though both have those billions in tax cuts and spending ideas factored into their campaign pledges.

So there’s every chance the rise in the cash rate to 6.75% won't be the last the way the RBA worded its statement.

That will be good for the dollar, importers, retailers like Harvey Norman and JB Hi-Fi, as well as helping Coles, Woolies and other groups expand their range of imported own brands, which will add to profit margins.

The shares of Woolies, Coles and Wesfarmers rose yesterday after the Coles shareholders voted for the WES merger, but there was also a bit of interest rate-driven defensive buying: people have to eat when rates go up, but they might not go out so much or buy a new car.

HVN and JB Hi Fi shares also rose because the Aussie dollar climbed well above 93 US cents.

Travel groups, such as Flight Centre are riding the boom, as are the few listed car dealers; any car company with a long list of imported brands should benefit handsomely.

Qantas and Virgin Blue should be big beneficiaries because of the lower Australian dollar impact of high jet fuel prices. Qantas' US dollar income will be hit but it does have US dollar borrowings as an offset.

The RBA's statement will be bad for exporters, especially the growing list of local companies telling the market and or shareholders of the potential damage the higher dollar is doing to overseas income.

In no order the list includes: CSL, the big miners and others, oil groups like Santos and Woodside, CSR, Cochlear, Fosters, Billabong, McGuigan Simeon Wines, Boral, Fairfax and tourist groups which face a slow down in visitors because of the higher cost of travelling with Australia.

The list goes on. Anyone exporting faces pricing and revenue pressures because of the higher currency.

But because of the continuing high price for commodities, and rising values for oil, and gas, gold, silver and iron ore next year, the impact of the higher Aussie will be able to be glossed over for another year or so by many of the big and medium producers in these areas.

Economists say the next rate rise will come after the March quarter CPI is released in late April. That's if the RBA doesn't see any evidence of moderating demand by then.

HSBC chief economist John Edwards says the RBA was likely to raise rates again in March 2008, as strong demand and a tight jobs market put upward pressure on inflation.

JPMorgan chief economist Stephen Walters said wages pressures were likely to intensify during the next 12 months, putting upward pressure on inflation.

"It's just the fact that domestic demand is too strong," he said.

"There're few signs of strength diminishing.

"The commentary from the Reserve Bank suggests there's another one coming."

Westpac senior economist Andrew Hanlan says rates could rise again before Christmas because underlying inflation - which excludes prices of volatile items - had grown at an annualised pace of 3.7% in the June and September quarters.

This was the first election campaign rate rise and it was also the one where the main thrust and slogan of the incumbent government has been so thoroughly repudiated by the independent RBA.

What the bank says by using the word 'moderate is to see employment slowing, and the unemployment edging higher, away from the present 33 year low of 4.2%.

The Prime Minister's boast that he wants an unemployment rate with a '3' in front of it, is now off limits so far as the RBA is concerned.

And if the new Government doesn't bend to its will, rates will rise until growth slows.

And the bank left open the possibility of another rate rise, if this demand in the economy doesn't slow. It dismissed the September quarter's Consumer Price Index which came in at 1.9%

"Inflation in Australia has increased. Underlying inflation was 0.9 per cent in the September quarter and close to 3 per cent over the past year.

"The annual pace of CPI inflation was lower, but this reflected two very low quarterly results nearly a year ago, as well as recent changes to the treatment of child care costs. By the March quarter of next year, both headline and underlying measures of inflation are likely to be above 3 per cent."

And that's why economists are talking about another rate rise. The bank would have to be convinced that cost pressures would peak at this level not to lift rates in March to May.

"The world economy is still expected to grow at an above-average pace, however, led by strong growth in China and other parts of Asia. High global commodity prices remain an important source of stimulus to Australian spending and activity."

From what the Bank says we clearly can't afford any more stimulus in the domestic economy.

And if the drought breaks and rural commodity prices rush higher as farmers re-stock and replant?

And the Bank believes the Australian economy and borrowers can afford a rate rise, even after the return of the subprime mortgage debacle and it’s undermining of confidence in US financial groups.

"In Australia, the tightening in credit conditions resulting from the global turmoil has been less pronounced than elsewhere. Wholesale funding costs have risen a little compared with official rates, and some borrowers have experienced an increase in interest costs as a result, but the flow of credit to sound borrowers does not appear to have been impaired."

That's the next penny to drop: watch which bank and lender tries to shuffle through higher than 0.25% rate rises for mortgages, credit card, margin loan, personal and car loans and lease costs, plus business finance.

The banks have all been warning of the funding pressures and asserting their right to lift rates more than what the RBA does: let's watch for the first to do it. Will it be Macquarie or Adelaide Banks, which have already lifted mortgage and other loan rates because of the funding pressures; or will it be one of the big five?

The Commonwealth said yesterday at its AGM that rates would rise, but went all coy on the size of the increase. It is the biggest home lender and can be more upfront than that with its customers.

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