RBA leaves rates on hold in August

The Reserve Bank left the cash rate on hold for the third month in a row in August at 4.25%. The last rise of 0.25% to 4.5% was initiated in May.

Tuesday' statement after the August Board meeting said: global growth is mixed but above trend; inflation was on track; unemployment is falling "gradually" (that's good); pressure on dwelling prices appears to have "abated"; and wages have picked up a little, "as expected".

Against this backdrop, the current setting of policy is "appropriate", full-stop. Last month it was appropriate "Pending further information about international and local conditions for demand and prices". This time, no proviso.

RBA Statement on Monetary Policy

More background information on the context of this week's RBA 'no hike' decision was released in today's quarterly Statement on Monetary Policy (SMP).

The SMP contained a myriad of detail on the economy and markets but our key take away from the report was the evolution of the RBA's forecasts. The key thing to note is that the RBA made virtually no changes to the economic outlook for 2011 and 2012, where their focus lies for the purposes of setting monetary policy. The table below shows the RBA's key forecasts.

Only the near term forecast for Q2 GDP seems to have been changed. That probably reflects the surprise record high balance of trade surplus for June, which must have pushed up their June quarter net exports component in GDP to around 1%. In turn that lifted the GDP forecast for the year to June 2010 to 3% from 21⁄2% in May.

These forecasts mean that the RBA can now remain comfortably on hold for the time being, putting significant risk that our current forecast of two rate hikes in November and December of this year will be delayed until 2010.

Note that we only envisage that rate hikes could be delayed, not cancelled. That is because the RBA cannot leave rates at 4.5% indefinitely (a level which translates to retail rates around "average levels") as the underlying inflation rate gradually trends high to 3% by mid-2012. To do so would be to risk the inflation rate to continue to trend up, breaking up through the top of the target band. Hence, the RBA needs to move to a setting on the tight side of neutral. To us this means that the RBA has an unstated tightening bias.

The unstated tightening bias probably reflects the RBA's conclusion "...the Board views the current setting of the cash rate as appropriate at this stage" (emphasis added).

According to the RBA, if the economy continues along their central forecasts track, from 2011 through the end of the forecasting period (2012) some tightening in industrial capacity and a gradual tightening in the labour market is to be expected. This is another pointer to the need to raise rates eventually, in order to ensure that the economy does not hit capacity constraints, a sure trigger for inflation.

With their forecasts looking good, the early tightening by the RBA has bought it time to watch and assess the data as it comes in. The RBA's SMP set out risks to both the upside and the downside for its central forecasts. Upside risks come from: a stronger than forecast global economy; firms attempting to push ahead with investment at too fast a pace, especially in mining; and household consumption bouncing back (the RBA assumes a higher household saving rate than was the case before the GFC).

Downside risks come from: private sector demand (investment) not rising as quickly as forecast; China tightening too hard causing their economy to grow more slowly than intended; and the possibility of another bout of financial crisis emanating out of Europe and a retreat in risk taking (they note the direct effects of weak Europe would be relatively limited).