Pre-election Tightening Has Become Irresistible

Case for a pre-election tightening has become irresistible

We changed our forecast on Monday to include two RBA tightenings in the first half of 2008, owing mainly to the significant deterioration in the medium term inflation outlook. With RBA officials already forecasting core inflation in the top half of the 2-3% target range out to the end of 2009, we believed the likely rise in inflation owing to the drought (mainly via higher food and electricity prices), elevated fuel prices, the drum-tight labour market, and the fiscal boost from pre-election government spending that is growing by the day, would be enough to tip RBA officials over the line in February and again in May. Also, residential rents, which have the second highest CPI weighting behind home construction, are soaring, and credit growth, which RBA officials already have identified as growing too quickly, accelerated in April.

This week's upside surprises on GDP and employment, though, which showed the economy growing well above its speed limit and the unemployment rate dropping even further below 'full employment', now makes us believe the RBA will tighten on July 4.

The main reason we believed the RBA could wait until early next year before tightening was the imminent plunge in annual headline inflation, owing to beneficial year-ago base effects from last year's spike in petrol and banana prices. Indeed, a tightening after the release of the Q2 CPI data in late July would be very awkward to explain - what credible central bank would raise interest rates immediately after annual inflation plunged? Not until the release of the Q4 CPI report in late January 2008 would the favourable annual inflation base effects unwind, and RBA officials have established a consistent track record since early 2006 of waiting for inflation prints before changing policy. Sticking to this inflation-rate hike 'pattern' would necessitate the RBA waiting until February before tightening, even if annualised (not annual) inflation readings were elevated.

Also, we favoured 2008 tightenings because we believed that RBA officials would want to avoid monetary policy becoming entangled with the Federal election. The election probably will be held in November - given the distance by which the Howard Government trails the Opposition in the opinion polls, Howard probably will delay the election for as long as possible. The election effectively rules out an RBA tightening between September and November.

In the wake of this week's firm data, however, we have had a change of heart. The case for a pre-election tightening strengthened substantially this week, so much so that the case for a pre-election tightening has become irresistible. The economy is growing even faster than the most optimistic punters believed possible, so the gap between actual and potential output growth has blown out - no wonder the economy is fast running out of spare resources. Indeed, the jobless rate has reached a new 33-year low - every State, even poor old New South Wales, now has a jobless rate below 5%. The plunge in the unemployment rate and growing evidence of staff shortages mean that wage growth is almost certain to accelerate from here, particularly if the post-election political climate shifts the balance of bargaining power back towards employees and the trade unions (i.e. if Labor wins the election).

The domestic inflation pressures - emerging from the tight labour market, the drought's impact on electricity and food prices, the fiscal boost, and the spike in petrol prices - come on top of the uncomfortably persistent inflation pressure globally, which in the past has been a focus of RBA policy deliberations. Worryingly, the spike in domestic fuel and electricity prices are the types of cost increases most likely to trigger second and third round price rises a firms act to maintain margins. Similarly, higher wage bills in coming months could prompt price rises, particularly with corporate pricing power returning owing to the health of the household sector.

Importantly, too, there has in recent days been a reassessment by markets of the global growth and inflation outlook in favour of firmer economic growth and earlier rate hikes by the major central banks. JPMorgan's forecasts continue to feature expected policy tightenings by the Fed, the Bank of England, the ECB, the Bank of Canada, the Bank of Japan, and the PBoC within the next six months (and fellow commodity exporters New Zealand and South Africa hiked yesterday). A rosier global growth outlook means there could be even further support for Australia's soaring terms of trade, which already has risen 40% over the last four years and has delivered a substantial boost to national income.

With the case for a near term tightening all but closed, the choice for the RBA, then, is between a July or an August tightening. The problem with a move in August is that the August Board meeting comes just days after the release of the Q2 CPI report, and beneficial year-ago base effects will drive headline inflation well below the bottom of the RBA's 2-3% target range. A tightening in August, therefore, would be very difficult to explain, particularly with interest rates and economic management likely to be key issues in the election.

That leaves July. A July move gets the tightening out of the way as far ahead of the election as possible, and avoids the difficulties of the RBA having to explain a rate hike soon after a plunge in the annual rate of inflation. The RBA can explain a July move by pointing to building medium term inflation pressure, while simultaneously acknowledging the likely plunge in inflation from the second quarter. This is a much easier, and less politically sensitive, approach than waiting for August, when the low Q2 CPI print will be arguing strongly for 'rates on hold', at least at face value. A post-election move in December is possible but, if the case is strong, why not move now?

Having reverted back to a pre-emptive policy approach and tightened in July, rather than waiting for an inflation trigger like in 2006, the RBA then can wait out the election campaign and the plunge in headline inflation, before returning with another rate hike in early 2008. The terminal cash rate for this cycle remains 6.75% (in line with out current forecast), but we get there earlier. Saving the tightenings for 2008 when the argument for pre-emptive tightening already is compelling risks having to push the cash rate beyond 6.75% next year, in which case the landing for the economy would be harder than otherwise would be the case.

The risk to the July rate hike call is that the credit and retail data due for release just before the July Board meeting could print on the soft side and keep the RBA on the sidelines, but it would take substantial downside prints to offset this week's upside surprises on GDP and employment. Crucially, the June employment data is released after the July Board meeting, so this week's unexpectedly low unemployment rate is the one Board members will take into the July policy meeting. We expect Governor Glenn Stevens in his speech next Thursday to acknowledge the emerging upside risks to the medium term inflation outlook.

ENDS

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