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The outlook for interest rates.
Date: Wednesday, 26th March, 2008. Source: MLC/Garvan Financial Planning.
In early March 2008, the Reserve Bank of Australia (RBA) raised the cash rate (interest rates) for the twelfth consecutive time since 2002, just one month after its previous rate hike.
The question many clients are asking is why, and will interest rates continue to climb?
In economic terms, Australia is doing very well. The economy has accelerated from growth rates of around 2.5% in late 2006 to around 4.0% in late 2007.
This has been driven by consumer spending on the back of tax cuts, solid employment growth, and the wealth effects of higher house prices and strong equity markets. There is also very strong public sector demand from federal and state government spending.
But with such strong growth, inflation has risen to around 3.3% and is likely to be 3.8% by mid year. This compares to the RBA’s target of between 2 and 3% per annum. Keeping inflation within this range helps keep the economy from overheating and is aimed at preventing boom and bust cycles.
Thus with inflation likely to be significantly outside the RBA’s target range, we expect a further rate rise in March and possibly another in May. Thereafter, much will depend on how much Australian demand slows – with an important role also for tighter fiscal policy as well.
The global factor
As the Australian economy is also influenced by the economic performance of other countries, the RBA looks closely at developments in international financial markets.
The United States is a key focus, particularly in the context of its ‘sub-prime’ lending problems. This has also been compounded by a large overbuild in the construction sector and falling housing prices.
“In the US we expect a growth recession – with GDP growing by only 1¼% in 2008” said NAB Group Chief Economist, Alan Oster.
Oster also believes the US Federal Reserve will continue to cut rates by at least 50 points and the US dollar will remain weak. Elsewhere among key G-10 economies growth is also slowing to around 1½%.
But Oster expects China to remain strong with growth around 10% in 2008. This would mean ongoing demand and high prices for Australia’s coal and iron ore exports. Iron ore prices look set to increase by 65% and coal by around 100%.
In this international context, the Australian economy is expected to continue to grow, but to slow to around 3% in 2008/09 – and somewhat slower outside the farm sector which is recovering from drought.
All this means we will see more rate rises in early/mid 2008. However with tighter fiscal and monetary policy settings likely to slow demand, we believe the RBA will be in rate cutting mode by mid 2009 (with around 125 points in cuts probable).
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