Economic Insights Rates up RBA makes courageous move

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					 Economic Insights
 Craig James, Chief Equities Economist, (02) 9312 0265 (wk), 0419 695 082 (02) 9525 2739 (hm) craig.james@cba.com.au



 Rates up: RBA makes courageous move
 RBA interest rates decision
 •      The Reserve Bank has increased official interest rates for the first time in 14 months, lifting the cash rate by a
        quarter of a percentage point (25 basis points) to 5.75 per cent.
 •      The Reserve Bank has cited stronger global conditions, higher domestic spending, the tight job market and
        increased demand for credit as factors prompting its decision to lift rates.
 •      CommSec expects that this will be the only increase in official rates in 2006.
 •      The Australian economy is likely to slow markedly in coming months. The housing sector will remain soft in the
        eastern and southern states with any recovery delayed until 2007. The fledgling recovery in consumer spending
        is also at risk, not only from higher interest rates but record petrol prices.


                                                The decision
MAY 3 2006
                                                •   The Reserve Bank has increased official interest rates for the first time since March 2
Produced by Commonwealth Research                   2005. The cash rate has been lifted by 25 basis points (a quarter of a percentage point) to
based on information available at the time
of publishing.        We believe that the
                                                    5.75 per cent.
information in this report is correct and any
opinions, conclusions or recommendations        •   This is only the second increase in official rates in 29 months. In fact Australia had been
are reasonably held or made as at the time
of its compilation, but no warranty is made
                                                    enjoying the most stable period for interest rates for over 32 years. Prior to the rate hike in
as to accuracy, reliability or completeness.        March 2005, there had been no changes in the cash rate in 2004, two rate hikes in 2003
To the extent permitted by law,neither
Commonwealth Bank of Australia ABN 48               and two rate hikes in 2002. By contrast, there were six rate changes in the entire 2001
123 123 124 nor any of its subsidiaries
accept liability to any person for loss or
                                                    calendar year, all rate cuts.
damage arising from the use of this report.
The report has been prepared without
                                                •  Repayments on the average home loan of $216,900 are likely to rise by around $34.50 a
taking account of the objectives, financial        month in response to the decision to lift the cash rate. Household budgets have already
situation or needs of any particular
individual. For this reason, any individual        been under pressure from higher petrol prices – with motorists forking out $26 a month
should, before acting on the information in
this report, consider the appropriateness of
                                                   more on fuel since the start of the year.
the information, having regard to the
individual’s objectives, financial situation    Overall analysis
                                                •
and needs and, if necessary, seek
appropriate professional advice. In the             This one is going to hurt. Not only are people having to contend with record petrol prices
case of certain securities Commonwealth
Bank of Australia is or may be the only
                                                    and rising health insurance costs but now they have to find the extra money to pay the
maket maker.                                        mortgage. There is no doubt that Aussie consumers will have to tighten their budgets,
This report is approved and distributed in
Australia by Commonwealth Securities                spend less at the shopping mall and attempt to pare back existing debt.
Limited ABN 60 067 254 399 a wholly
owned but not guaranteed subsidiary of          •   The Reserve Bank has had a good track record with interest rate changes over the past
Commonwealth Bank of Australia. This
report is approved and distributed in the           decade and we hope that it has similarly shown good judgement in lifting rates this time.
UK by Commonwealth Bank of Australia
incorporated in Australia with limited
                                                    This is certainly a courageous decision to lift interest rates as justification for the move
liability. Registered in England No. BR250          was far from water-tight. Consumer spending is still getting up off the floor, the housing
and regulated in the UK by the Financial
Services Authority (FSA). This report does          market is patchy and manufacturers are doing it tough – hit not only by the firm Aussie
not purport to be a complete statement or
summary. For the purpose of the FSA
                                                    dollar but competition from China. And while headline inflation is at 3 per cent, a number
rules, this report and related services are         of key measures of underlying inflation are closer to 2 per cent.
not intended for private customers and are
not available to them.                          •   With all the media focus on interest rates, and the risk that this could become destabilising
Commonwealth Bank of Australia and its
subsidiaries have effected or may effect            for the economy, the Reserve Bank probably took the view that it was worth getting the
transactions for their own account in any
investments or related            investments
                                                    rate hike out of the way. Ongoing
referred to in this report.                         uncertainty about rate hikes would
                                                    have been damaging for consumer
                                                    confidence,      creating      negative
                                                    momentum for the economy.
                                                •   The Reserve Bank will certainly get
                                                    plenty of bang for its buck with the
                                                    latest rate move. The rate increase
                                                    together with the huge announcement
                                                    effects will have a marked impact on
                                                    economic activity. The Reserve Bank
                                                    believed that the last rate hike was
                                                    equivalent to 50 basis points in
                                                    impact, and this move will have similar
                                                    effects.
Economic Insights
             •   We believe that this will be the only change in interest rates that we will see this year. The
                 case for a rate hike wasn’t overwhelming and any further lift in rates would create the risk
                 of the economy going backwards.
             •   Monetary policy has now become contractionary, or acting to slow economic activity. At
                 the previous level of the cash rate at 5.50 per cent, monetary policy was neutral – neither
                 serving to boost economic growth or slow it down.
             •   Discretionary spending will be hardest hit by the rate hike, affecting businesses such as
                 cafes, newsagents, take-away food and video hire outlets. And while house sales and
                 construction should soften in response to the lift in rates, perhaps hardest hit is the rental
                 market. Vacancy rates are already tight, pushing up rents, and the situation is likely to get
                 even tighter in coming months with less units and apartments being built.
             •  We don’t expect the sharemarket to be too adversely affected by the rate hike. In fact it
                will have the positive spin-off in deflating some of the excessive exuberance that has been
                building up. But the Australian economy will soften in coming months, restraining earnings
                growth and therefore putting the sharemarket on a flatter trajectory. We expect the ASX
                200 to reach 5,500 by December.
             Justification for the move
             •   The Reserve Bank noted the following:
                    International developments are continuing to provide stimulus to growth in Australia.
                    The world economy is growing at an above-average pace for the fourth successive
                    year and, significantly, forecasts have recently been revised upwards. Commodity
                    prices have been increasing strongly for some time, and they have risen further in the
                    year to date. This suggests a strengthening in the outlook for Australia's export
                    earnings, with consequent expansionary effects on incomes and spending.
                    In Australia, domestic spending has been growing at a solid pace recently and
                    prevailing conditions suggest that this is likely to continue. High profitability and rising
                    share prices are indicative of a favourable business environment in which investment
                    growth is likely to remain strong. There are also signs that the dampening effects of
                    household balance-sheet adjustment on consumer spending are starting to wane.
                    Recent trends in credit growth indicate that households and businesses have
                    continued to find it attractive to borrow at prevailing interest rates. After touching a low
                    point in the September quarter, the growth of household credit has picked up over the
                    two most recent quarters. Business credit growth has continued to trend upwards. A
                    factor that is likely to have contributed to the overall strength of credit growth has
                    been the continuing compression of lending margins by financial intermediaries over
                    recent years, reflecting competition among lenders. As a consequence, although the
                    cash rate has been close to its historical average, interest rates paid by borrowers
                    have remained below average.
                    These domestic and international trends have added to inflationary pressures in an
                    economy that has been operating for some time with rather limited spare capacity and
                    low unemployment. Wages growth, though not accelerating further recently, is higher
                    than it was a year ago, and businesses are continuing to report that suitable labour is
                    scarce. Raw materials costs continued to increase strongly in the March quarter,
                    reflecting the general strength in global commodity prices. Consumer price inflation
                    has picked up to around 3 per cent in recent quarters. While this partly reflected rising
                    fuel costs, underlying consumer
                    price inflation also increased in the
                    March       quarter,      to     around
                    2¾ per cent, a rate it had not been
                    expected to reach until the second
                    half of the year.
                    Taking all of these developments
                    into account, the Board judged at its
                    May meeting that inflationary risks
                    had increased sufficiently to warrant
                    an increase in the cash rate.
             •   The Reserve Bank must always be
                 forward-looking in setting interest rates.
                 So it is clear that the Bank was worried
Economic Insights
                about the upward momentum in inflation, pointing to underlying inflation breaching 3 per
                cent. The last thing the Reserve Bank would want to see is inflation getting locked in at
                higher levels. If more and more people believe that inflation is 3 per cent, rather than 2.5
                per cent or 2 per cent, there is a risk that this higher level could get locked in to wage and
                price setting and inflation psychology.
             The Upcoming Budget
             •   If there is a good news element to the rate hike it is that the Federal Government will have
                 less concern about handing back some of its near-record surplus to consumers when it
                 delivers the Budget next Tuesday. Tax cuts are certainly on the way, having being
                 announced last year. And increases in welfare payments to families are also on the
                 agenda.
             •   The Reserve Bank governor has indicated on a number of occasions that fiscal policy or
                 budget changes have not been a concern for the central bank over recent years. Fiscal
                 policy effectively tightens during each year as shown by the rising budget surplus and
                 then the Government hands that back in July with tax cuts or spending increases. But
                 overall the budget surplus isn’t moving too far from levels of around 0.5 per cent of GDP.

             Craig James, Chief Equities Economist, CommSec
             Work: (02) 9312 0265;
             Home: (02) 9525 2739;
             Mobile: 0419 695 082

				
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Description: Economic Insights Rates up RBA makes courageous move