Take a long view on interest rates

TRADERS in financial markets love a bit of volatility, but they also like to know what policy makers are planning so they don’t get caught out.

The Reserve Bank’s decision this week to keep official interest rates on hold was a rare shock to financial markets; an increase in rates had been universally expected by highly paid market economists who are supposed to be able to predict these things.

Indeed, some commentators had castigated the Reserve for not being more aggressive in its monetary policy tightening, arguing that housing price data pointed to the emergence of an asset price bubble.

The strongest evidence for this was the extraordinary 19.7 per cent jump in Melbourne house prices over the year to December.

Rather than being spooked by fears of an asset bubble, the Reserve chose instead to hold its fire, stating that it needed more time to assess the impact of the three interest rate increases it pushed through in October, November and December.

“Lenders have generally raised rates a little more than the cash rate over recent months and most loan rates have risen by close to a percentage point,” RBA governor Glenn Stevens said.

“Since information about the early impact of those changes is still limited, the board judged it appropriate to hold a steady setting of monetary policy for the time being.”

The most revealing paragraph followed, when Mr Stevens said interest rates to most borrowers remained lower than average.

“If economic conditions evolve broadly as expected, the Board considers it likely that monetary policy will, over time, need to be adjusted further in order to ensure that inflation remains consistent with the target over the medium term.”

In other words, borrowers have a short reprieve but should plan for further substantial interest rate increases, possibly up to another one percentage point.

This is the downside of Australia’s surprisingly resilient economy. As the only developed country to have escaped the international recession of 2009, Australia is sometimes described as a global oddity.

The positive outlook was highlighted by the International Monetary Fund’s latest growth forecasts, released last week

The new IMF forecasts put world growth at 3.9 per cent this year – up 0.8 per cent from its previous forecast – and 4.3 per cent next year.

This positive global picture disguises wide variations.

Growth in what the IMF calls ‘advanced countries’ is expected to average only 2.1 per cent this year and 2.4 per cent in 2011.

In other words, the US, Europe and Japan will struggle on with modest growth and unemployment will remain high.

Australia sits among the advanced countries and will outperform its peers, with growth expected to be 2.5 per cent in 2010 and 3 per cent in 2011.

The engine of global growth remains non-Japan Asia. The IMF estimates that China’s growth rate will be about 10 per cent while India’s growth rate will be close to 8 per cent.

The positive global outlook, particularly in Asia, was one reason the Chamber of Commerce and Industry WA lifted its forecasts for the state’s growth.

CCI expects WA’s economy to grow by 1.5 per cent in 2009-10, up from its previous forecast of 0.25 per cent.

The growth rate will rapidly accelerate as business investment on large resources projects, led by the Gorgon gas development, kick in.

Growth is tipped to reach 4.25 per cent in 2010-11, followed by 5 per cent in the following financial year and then 6 per cent in 2012-13.

“The local impacts of the global economic slowdown will soon be a distant memory, as Western Australia enters the new decade poised to enter a fresh era of economic growth and prosperity,” CCIWA chief economist John Nicolau said last month.

“Within months, the state has gone from the verge of recession, to now ramping up for growth that will be the envy of the nation.”

“The turnaround in the state’s economic fortunes has been impressive.”

The rapid growth will bring cost pressures. Not only will interest rates increase, but wage pressures will rise, as will rents, material costs and many other business inputs.

That is the outlook upon which business plans should be based.