27 May 2009

Economic Imbalances

Australia’s central bank felt keeping interest rates at very low levels could undermine the achievement of its inflation target over the medium term, leading to economic imbalances.

Minutes of the Reserve Bank of Australia’s (RBA) Oct. 6 policy meeting showed board members thought downside risks to the economy had diminished over recent months and keeping the cash rate at a very expansionary setting was possibly imprudent.

At the meeting the central bank raised its key cash rate to 3.25 percent from a record low of 3.0 percent, a move that surprised many and highlighted the outperformance of the local economy. While announcing the decision, the RBA also indicated it would raise rates further, leading markets to price in at least two rate hikes before the year end.

“While downside risks to the domestic economy could not be ruled out, they had diminished significantly over recent months,” the minutes said. “This meant that the balance of risks was not such that the current very expansionary setting of policy was no longer necessary, and possibly imprudent.”

“Keeping interest rates at very lows levels for an extended period could threaten the achievement of the inflation target over the medium term.”

Last week, Governor Glenn Stevens said in a speech that the risks of serious economic weakness had abated and that he would not be timid in removing some of the monetary stimulus put in place to help the economy ward off the worst of the global financial crisis. He added that over a period of time, the cash rate would be raised to a normal rate setting.

Stevens also said that as the economy grew, the RBA’s objectives would be to keep inflation low. The RBA aims to keep inflation in a 2-3 percent band, but second-quarter underlying consumer prices were 3.9 percent higher than a year ago. His comments have brought focus on the third-quarter inflation report, due on Oct. 28, and an upside surprise could see markets increase bets on a 50 basis point hike in November.

The board noted that underlying inflation was above the target and, while current forecasts suggested it would fall in the coming year, the expected trough in inflation was significantly higher than earlier thought.

“Inflation was expected to decline in the near term, reflecting both the current level of spare capacity and relatively slow growth in labour costs,” the minutes said. “However, the forecast trough in inflation was not as low as previously expected, and by 2011 inflation could be rising again.”

The RBA minutes pointed to a resilient jobs market. The bank’s liaison with businesses indicated the extreme caution in hiring plans earlier in the year were being gradually unwound. Australian employment surged past all expectations in September while the jobless rate dropped to 5.7 percent from 5.8 percent.

The board also noted that growth was expected to be around trend in 2010 and subsequently strengthen, helped mainly by its strong ties to Asia.

Australia is one of the very few developed nations to dodge a recession, with its housing and banking sectors holding up well compared with a battering in those areas in the West. In addition, its largest export markets are in Asia, dominated by China, South Korea and India, economies that have weathered the global downturn in reasonably good shape.

The RBA’s liaison showed households were relatively resilient with motor vehicle sales quite strong. House prices are estimated to have risen around 2 percent in August while data from private sector providers suggested nationwide prices were above the peaks seen in late 2007 and early 2008.

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