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Thursday, November 12, 2009

RBA lifts rates by 25 basis points

Reserve Bank Board meeting

• The Reserve Bank (RBA) has increased interest rates for the second consecutive month, lifting the cash rate from 3.25 per cent to 3.50 per cent.
• The RBA said “it is prudent to lessen gradually the degree of monetary stimulus that was put in place when the outlook appeared to be much weaker.”

What does it all mean?
• The Reserve Bank certainly hasn’t sought to frighten the horses with the latest rate hike. All and sundry had expected a move of 25 basis points and the Reserve Bank didn’t disappoint. At this point in the cycle, a move of 25 basis points strikes a nice balance – it edges the cash rate back to more normal levels without threatening the economic recovery. There has been little change in the wording or tone of the statement, suggesting that the RBA will continue to lift rates in 25 basis point increments.
• It is far from certain that rates will rise again in December. The Reserve Bank has never lifted rates for three consecutive months, although it did cut rates five consecutive times late last year and early this year in the midst of the global financial crisis. While the Governor did warn that he wouldn’t be timid in removing monetary stimulus, the Reserve Bank has already lifted rates twice at a time when other central banks are solidly on the sidelines. In addition inflation continues to ease, especially once housing is stripped out, and the firmer currency will assist in keeping inflation contained over the next 6-9 months. We expect the next tranche of rate hikes in February and March 2010.
• A year from now the cash rate will most likely be around 4.50 per cent – a level that will make the Reserve Bank much more comfortable. While a cash rate around 5 per cent has been regarded as a ‘neutral’ monetary policy setting in the past, this may prove too high if the Aussie dollar remains close to, or above, US90 cents. A strong currency not only leads to lower prices of imported goods and lower inflation but makes it tough for exporters and tourism.

Interest rate decision and past cycles
• The Reserve Bank has lifted rates for the second straight month – the first back-to-back rate hike since March 2008. The cash rate was lifted by 25 basis points to 3.50 per cent. Rates had stood at a 49-year low of 3.00 per cent before the decision in October to lift the cash rate.
• The first rate hike in the new cycle occurred six months after rates were last reduced back in April 2009. There were six rate cuts in the last cycle with the cash rate cut from 7.25 per cent to 3.00 per cent. Interestingly the previous tightening cycle in 2002 also began six months after the final rate cut was delivered.
• If banks pass on the interest rate increase in full then repayments on a 25-year $300,000 home loan will increase by $46.21 a month. Even with the rate hike, monetary policy is still clearly expansionary. The Reserve Bank has previously indicated that the “normal” or neutral cash rate is around 5.00 per cent. A neutral cash rate means that monetary policy is neither expansionary nor contractionary.
• The Reserve Bank has now adopted a “tightening” bias. That is, the RBA has indicated that further rate hikes are likely in coming months: “it is prudent to lessen gradually the degree of monetary stimulus that was put in place when the outlook appeared to be much weaker.”

What are the implications for interest rates and investors?
• Around a third of people rent, a third of people own their homes outright and a third of people are buying homes. But over time, the proportion of home owners with a mortgage has been rising. So the community is far more interest rate sensitive. Still, when rates were coming down in 2008, many home buyers elected not to cut their loan repayments. So with interest rates still historically low, there will be negligible effects on the economy. But the Reserve Bank must be careful when lifting rates in 2010 – arguably it went too far with rate hikes in 2007 and early 2008.
• The Reserve Bank will continue to ‘normalise’ rate settings over 2010 – that is, lift rates to more ‘normal’ levels in line with more ‘normal’ economic conditions.
• Apart from Australia, only Israel and Norway have lifted interest rates. The longer that Australia effectively ‘goes on its own’ in lifting rates (at least compared with major economies) the higher the Australian dollar is likely to go, constraining earnings for globally-focussed companies. The Reserve Bank has continued to highlight that the Aussie dollar will act as a dampening influence on tourism and export sectors and constrain inflation.

Source Craig James, Chief Economist, CommSec