Rates Gloom

By Glenn Dyer | More Articles by Glenn Dyer

No relief on interest rates for at least two years and there's every indication we could get one or two more rises from the Reserve Bank if inflation doesn't behave.

There's also an expectation that the economy will have to slow significantly to get inflation lower and that will mean a rise in unemployment, perhaps to levels we haven't seen for several years.

And it could mean housing mortgages above 10%.

The RBA made it much clearer in its first Monetary Policy Statement of the year, released yesterday, that it is very worried about the inflationary outlook, and hence to expectation that it could be 2009-2010 before it retreats to around 3%, the top of its target range.

The only thing that seems capable of changing this outlook is a sharp drop in the world economy, especially China, which would help take the pressure off the capacity constrained Australian economy.

It significant expanded on last week's statement with the increase in the cash rate to 2007 and at times it makes somewhat gloomy reading.

It will weigh on sharemarkets (knowing that bank deposits could be paying upwards of 8% a year gross by the end of the year) and it will cheer some retirees and other savers.

"Absent a further shift in economic risks to the downside, therefore, monetary policy is likely to need to be tighter in the period ahead," the RBA said.

"Given the current strength of domestic demand and pressures on capacity, a significant moderation in demand will be needed if inflation is to be satisfactorily reduced over time.

"There are a number of forces at work that could contribute to such an outcome, though the extent of the downward pressure they will exert on inflation is uncertain.

"Taking into account these factors, including the Board's decision to increase the cash rate in February, inflation is forecast to decline gradually from late this year, but would still be around 3 per cent in two years time.

"It is possible that there will be a sharper downturn in the world economy than is currently forecast, and there is also a risk that tighter credit supply could constrain demand and activity in Australia to a greater extent than is assumed. Should those risks eventuate, inflation would fall more quickly than is currently forecast."

Reinforcing its concerns about price pressures in the economy, the RBA has revised up its forecast for underlying inflation, suggesting it will remain well above its target band of between 2% and 3% for the remainder of 2008.

The RBA is forecasting underlying and CPI inflation to decline gradually in 2009, to around 3.25%, before falling to 3% in 2010.

"Underlying inflation is forecast to be around 3½ per cent over the year to the December quarter 2008," the bank said in a detailed look at the outlook for the Australian economy and inflation.

"The forecast of a continuing high level of underlying inflation reflects the expectation that pressures on capacity will remain for some time. Indeed, in the near term, it is likely that the year-ended rates of underlying and headline inflation will rise somewhat from current levels, reflecting the succession of large quarterly increases in the three latest quarters.

"Underlying inflation is expected to fall gradually in 2009 and beyond, to around 3 per cent at the end of the forecast period in mid 2010, with CPI inflation forecast to follow a similar pattern.

"This reflects the forecast moderation in demand growth and a gradual easing in capacity pressures which are expected to reduce the pricing power of businesses and alleviate wage pressures.

"Over the next year, the recent pattern of subdued tradables inflation and very strong non-tradables inflation is forecast to continue.

"However, further out in the forecast period, the dampening impact of the appreciation of the exchange rate can be expected to wane, and tradables inflation could be expected to contribute a little more to overall inflation.

"Hence the forecast slowing in overall inflation will require a significant slowing in non-tradables inflation, which will depend on a noticeable easing of capacity pressures in the domestic economy.

"Risks to these forecasts can be identified in both directions.

"A further deterioration in the outlook for global growth represents the main source of downside risk to the forecasts for domestic activity.

"In particular, if the weakness in the developed world were to lead to a more marked slowing in China and the other developing Asian economies than currently assumed, it is likely that the outlook for the Australian economy and commodity markets would deteriorate significantly.

"This would be expected to lead to some easing in growth of domestic incomes, spending and activity, and hence some further moderation in inflation over time.

"In addition, there is also a risk that the current dislocations in capital markets could worsen and result in a significant reduction in credit to households and businesses, which could lead to a more considerable slowing in domestic growth.

"There are also upside risks to the domestic growth and inflation forecasts.

"It is possible that the boost to the terms of trade over recent years will provide a larger ongoing stimulus to the domestic economy than has been assumed, and that domestic demand does not slow as much as forecast.

"If demand were to be stronger than expected, the forecast easing in the inflation rate would be unlikely to eventuate with the current policy settings.

"Most importantly, if it is not reversed reasonably quickly, the recent pick-up in inflation carries the risk of generating an upward drift in inflation expectations, which could feed back into wage-and price-setting behavio

About Glenn Dyer

Glenn Dyer has been a finance journalist and TV producer for more than 40 years. He has worked at Maxwell Newton Publications, Queensland Newspapers, AAP, The Australian Financial Review, The Nine Network and Crikey.

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