ANZ RESEARCH

AUSTRALIAN ECONOMIC UPDATE MONETARY POLICY CHANGE OF VIEW

4 JULY 2011 CONTRIBUTOR

Ivan Colhoun Head of Australian Economics and Property Research +61 2 9227 1780 Ivan.Colhoun@anz.com

MONETARY POLICY: A LONGER, SLOWER TIGHTENING CYCLE? Key Points: More mixed conditions in sectors of the economy outside of mining are producing a slowdown in job advertising and employment growth. This is likely to see the RBA leave official interest rates unchanged until February 2012. In the medium term, as the benefits of the mining investment boom broaden through the economy and unemployment continues to decline, the RBA will continue to raise interest rates. ANZ now forecasts a longer, slower tightening cycle with rates expected to reach 5.75% in the second half of 2013.

Australian interest rate markets are currently flirting with the idea that the next move in interest rates might be down. In recent weeks, the market has at times fully priced a 25bp easing by the RBA over the next six months. Mainly, this has reflected concerns that the Greece sovereign debt situation could trigger further financial market dislocation, together with a run of weaker than expected US economic data and market positioning, rather than a realistic domestic scenario whereby Australian inflation and economic developments would permit the RBA to begin to reduce interest rates any time soon. The RBAs publicly-stated central scenario continues to be one where the scale of mining investment and broad economic strength in Asia more than offsets continuing relatively weak growth in the US and Europe, which when combined with low Australian unemployment, leads to a gradual rise in Australian inflation toward the top of and even slightly above its 2-3pct target band on a 12-18 month horizon. Consequently, the Bank has stated that there likely remains a need to tighten monetary policy further at some point if economic activity and inflation indeed turn out as forecast. Its likely that the RBAs central case includes a restructure or organised default by Greece. Such an outcome would only drive a monetary policy response if second-round effects affected equity markets, funding markets, counterparty risk assessments and consumer and business confidence more generally. While recent communications from the Bank have reiterated this medium-term tightening bias, this months Board Minutes reveal that the inflow of global data (softer than expected), increased downside risks to the international economy associated with European sovereign debt concerns and still quite subdued activity in other important parts of the Australian economy had not added any urgency to the need for an adjustment to policy. As a result members judged it would be prudent to leave the stance of policy unchanged, pending further data on international developments and on the strength of domestic demand and inflationary pressures.

Monetary Policy Change of View / 4 July 2011 / 2 of 6

While the RBA has been very vocal in its hawkish outlook for rates based on the mining investment boom and low unemployment rate, there is reasonable debate in markets as to whether the strength of the non-mining sectors of the Australian economy justifies even a further move at the present time, let alone a series of such moves (more on that below). At the same time, global indicators have taken on a softer tone in recent months, likely reflecting the run up in oil prices in late 2010/early 2011 coupled with disruptions to global supply chains associated with the Japanese earthquake and tsunami. Both of these effects are now reducing and the prospects of stronger second half growth in the US appear sound barring a sovereign debt incident that issues in significant equity market weakness. If current global concerns subside, focus will return to Australian domestic fundamentals. The range of indicators reviewed in the charts below supports the view that the non-mining Australian economy is exhibiting considerably less broadbased strength than in the first phase of the commodities boom (especially from 2006 until the first half of 2008): (i) the unemployment rate is around one percentage point higher especially in the mining states; (ii) employment growth has slowed considerably in both the mining and non-mining states and is currently growing at a rate consistent with unemployment beginning to rise; (iii) business conditions and capacity utilisation are at lower levels across the economy; (iv) job advertising is improving more modestly (and in fact has broadly levelled off or even begun a slight decline in recent months at a much lower level than at the peak of prior labour market tightness. Historically, declining job advertising has been inconsistent with rising interest rates and in fact has usually been a forewarning of lower interest rates); and (v) population growth has moderated significantly from boom-time rates. With consumers still showing a desire to reduce debt and the RBA already having enacted a relatively tight monetary policy setting (as measured by the level of the debt servicing ratio in an overall weaker economy), the argument for a series of aggressive rate rises appears weaker. The high AUD will also remain an additional constraint on a number of sectors. The most reasonable approach to monetary policy at the present time would appear to be for the RBA to maintain current interest rates and monitor developments in broader macroeconomic indicators. With debt servicing ratios high and consumers remaining cautious, the most likely scenario is that the RBA makes at most another small tap on the brakes in the next 3-6 months, and thereafter that interest rates rise further, albeit relatively slowly, as the benefits of the mining investment boom broaden throughout the economy. Indeed given continuing mixed domestic economic conditions ANZ now forecasts that the RBA will leave cash rates unchanged until February 2012, by which time the benefits of the mining boom should be spreading more broadly throughout the economy and the US economy should have recovered from H1 2011 softness. So far, indications that the next move in rates could be lower do not appear strong in the absence of a global shock. Developments in the non-mining economy, however, suggest there is some possibility of a modest easing cycle on a 12-18 month timeframe, should, inflation continue to print at 0.5% q/q (or less), the non-mining sector remain weak and employment growth subdued. While quarterly inflation readings will remain important to the RBAs forecasts of inflation, developments in the labour market indicators are likely to provide the best overall summary of the host of divergent forces impacting on the Australian economy at the present time. The recent slight declining trend for job advertising bears close watching, as historically, such a trend has been inconsistent with rising interest rates.

Monetary Policy Change of View / 4 July 2011 / 3 of 6

In terms of the main risk scenarios about our revised forecasts: Further tightening: in the very short term, this seems likely to require a higher than expected Q2 CPI outcome in late July (0.8% qoq for core or higher), which we do not expect (ANZ forecast +0.6% q/q). Medium term, while we still expect that inflation will trend higher, the recent fall in oil prices has taken some pressure off inflation forecasts in the near term. Easing: this risk scenario must now also be considered. In the short term this would seem to require a GFC II type shock, likely emanating from sovereign debt concerns. In the medium term, an extended period of soft or softening global growth and lower commodity prices that sees core inflation remain moderate in the lower half of the band (0.5% per qtr or below), employment growth remain sub par and the unemployment rate begin to drift up could also see the Bank change its view about the current setting of monetary policy. The Bank would need to concede at some point that its current monetary policy settings were already a little tight in spite of the looming mining investment boom, given the ongoing headwinds of fiscal consolidation and consumer balance sheet deleveraging. This could see the RBA ask the question, as it did in 1995/96, as to whether the economy could afford to grow a little more quickly without threatening inflation. This seems unlikely before mid 2012 at the earliest, however, the last Board Minutes did hint more strongly that the Bank might be changing its view about the overall strength of the non-mining sectors of the economy.
FIGURE 1. MARKET PRICING AS OF 4 JULY 2011
BP PRICED current rate Jul-11 Aug-11 Sep-11 Oct-11 Nov-11 Dec-11 Jan-12 Feb-12 Mar-12 Apr-12 May-12 Jun-12 Jul-12 Aug-12 Sep-12 Oct-12 Nov-12 Dec-12 -0.01 0.00 -0.03 0.01 0.00 -0.01 0.00 0.01 0.02 0.02 0.02 0.03 0.03 0.03 0.03 0.02 0.01 -0.04 -0.01 -0.01 -0.04 -0.03 -0.03 -0.04 -0.04 -0.03 -0.01 0.01 0.03 0.06 0.09 0.11 0.14 0.16 0.17 0.13 CUMULATIVE BP EXP CASH RATE 4.75 4.74 4.74 4.71 4.72 4.72 4.71 4.71 4.72 4.74 4.76 4.78 4.81 4.83 4.86 4.89 4.91 4.92 4.88 ANZ FORECAST 4.75 4.75 4.75 4.75 4.75 4.75 4.75 5.00 5.00 5.00 5.00 5.00 5.00 5.25 5.25 5.25 5.25 5.25

Source: ANZ

Monetary Policy Change of View / 4 July 2011 / 4 of 6

FIGURE 2. VARIABLE DISCOUNT MORTGAGE RATE VS UNEMPLOYMENT RATE

10 9 8 4.5 7 6 3.0 3.5 4.0

% of labour force

5.0 5.5 6.0 6.5

Sources: ANZ and ABS

FIGURE 3. SAVINGS RATE AND DEBT SERVICING RATIO

16 Forecast 16 14 14 12 10 8 10 6 4 8 2 0 -2 4 1993 1995 1997 1999 2001 2003 2005 2007 2009 2011 -4 % %

Sources: RBA, ABS and ANZ

%
5 4 7.0 3 2 2004 2005 2006 2007 2008 2009 2010 2011 7.5 8.0

Variable discount rate, LHS

Unemployment rate, inverted RHS

12

Debt Servicing Ratio LHS

Household savings ratio RHS

Monetary Policy Change of View / 4 July 2011 / 5 of 6

FIGURE 4. CAPACITY UTILISATION VS VARIABLE HOME LOAN RATE

86 85 84 83 82 6 81 80 79 78 2005 2006 2007 2008 2009 2010 2011 averages since 2004 5 4 3 2 % NAB business survey capacity utilisation, 3 months fwd (lhs) Variable home loan, discounted rate (rhs) 11 10 9 8

FIGURE 5. SEEK NEW JOB ADS VS RBA OFFICIAL CASH RATE

450 400 350 300
Index SEEK new job ads v RBA official cash rate

7 %

5
%

250 200 150 100 05 06 07 08 09 10 11

SEEK new jobs ads lhs RBA cash rate rhs

FIGURE 6. EMPLOYMENT: MINING VS NON-MINING STATES (S.A.)

40 35 30 25 20 15 10 5 0 -5 -10 05 06 07 08 09 10 11

FIGURE 7. JOB ADVERTISING TRENDS: MINING VS NON-MINING STATES

Index, average 2002-04 = 100 (s.a.) 800 700 600 500 400 300 200 100 Jul 2005 NSW Jul 2006 VIC Jul 2007 Jul 2008 QLD Jul 2009 WA Jul 2010 Jul 2011 AUS

'000s of people, trend

Mining States

Non-mining States

Australia

FIGURE 8. UNEMPLOYMENT RATE MINING VS NONMINING STATES (TREND)

6.0

FIGURE 9. BUSINESS CONDITIONS AND CAPACITY UTILISATION WEAKER THAN PRE GFC
85 84 % of total capacity 83 82 81 80 79 78 77 76 1997 1999 2001 2003 2005 2007 2009 2011 25 20 15 10 5 0 -5 -10 -15 -20 Index

5.5

5.0
% (trend)

4.5

4.0

3.5

3.0 05 06 07 08 09 10 11

Mining States

Non-mining States

Australia

Capacity utilisation (LHS)

NAB Business Conditions (RHS)

Sources: ANZ, RBA, NAB, SEEK and ABS

Monetary Policy Change of View / 4 July 2011 / 6 of 6

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