Australia and New Zealand - Weekly Prospects 7/8

Australia and New Zealand - Weekly Prospects

* We expect the RBA to raise the cash rate 25bp on Wednesday. Last week's off-the-scale growth in credit in June (which, admittedly, was boosted by one-off borrowing to invest in pensions) and booming retail sales highlighted the need for tighter policy. This data follows the significant upside surprise on core inflation in Q2. Not tightening now owing to anxiety about global financial instability would push the tightening closer to the election. Clearly, this would heighten the political sensitivity of higher rates. Also, letting the booming economy run unchecked, despite RBA officials having two clear 'smoking guns' in the form of elevated core inflation and booming real economy indicators, risks the cash rate having to rise even more aggressively after a November election.

* Monday's New Zealand labour cost index showed wages growth above 3%oya, a rate consistent with building inflation pressure in the pipeline. The current rate of wages growth in will be enough to keep the RBNZ at action stations. The RBNZ last week submitted five recommendations to a Parliamentary select committee reviewing the effectiveness of monetary policy. While any policy changes are likely to take considerable time to implement, unless government policy addresses the constraints inhibiting housing supply, upward pressure on house prices will remain, and the RBNZ will be forced to keep interest rates higher for longer. The cracks in business confidence widened further in July as a record high OCR took a toll on expectations.

* Two recent developments challenge our 2H07 forecast of above-trend growth for the US and global economy. First, financial markets now are repricing credit risk in a manner that has created a logjam and that is promoting a more generalized reduction in risk appetite—the risk of a significant tightening in financial conditions in which creditworthy borrowers are constrained has increased. Second, there has been a loss of momentum in growth indicators in recent weeks. Much of this downshift is concentrated in the US, where home sales and consumer spending have disappointed. Despite a July dip, though, our global PMI survey continues to point to solid gains in manufacturing and overall growth.

* We no longer forecast a Fed rate hike as the economy turns into 2008—the forecast now is for a more extended pause with the FOMC on hold until mid-2008. This change is motivated by two factors. First, while we continue to look for a growth rebound, concerns around housing market "tail risks" are set to linger longer. These concerns are being reinforced by the turmoil created by the broader repricing of credit risk. Second, the Fed's patience has likely been reinforced by a better than expected core inflation outcome during the first half of 2007. In making this change we recognize that recent financial market stresses increase the risk of a financial market accident that forces the Fed to respond by easing. We do not, however, place a significant probability on this event at this stage (15%).

See... AusNZ_weekly_070807.pdf

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