Case for Future Rate Hike Building Slowly

After lingering around the US¢93 mark for several months, the Aussie dollar recently depreciated by approx. US¢5, while other domestic and international economic data continues to be mixed. This fall should help stimulate and rebalance the domestic economy but the extent is uncertain. The CAMA RBA Shadow Board recommends that the cash rate remain at its current level, yet there is growing confidence that it ought to be raised in 6-12 months. The Board attaches a 71% probability that the cash rate ought to remain at 2.5% in October. The confidence attached to a required rate cut equals 4%, while the confidence in a required rate hike has increased to 25%.

The aberrant spike in Australia’s unemployment rate in July 2014 has been reversed but slack in the labour market remains. (The unemployment rate equals 6.1%.) Wage pressure is thus no serious concern. There is no new inflation data available. However, should the Aussie dollar’s relative weakness persist, this will add inflationary pressures to the domestic economy. Business indicators are weaker, with the NAB Business Confidence, the Manufacturing PMI, and the Westpac consumer confidence index all deteriorating slightly. Estimates of GDP growth are largely unchanged. The construction industry is still responding positively to the housing boom. Increased military and security expenditures will put pressure on the federal government’s bottom line while key budget measures have yet to secure passage through the Upper House.

The foreign exchange market has come out of hibernation during the past few weeks. The Aussie dollar lost US¢5, partly due to the relative strength of the US dollar, partly due to retreating commodity prices. A weaker dollar ought to help boost non-mining exports; however, weaker commodity prices will hurt the mining sector.

The global economy is not faring as well as hoped. US GDP growth looks solid but falling inflation expectations raise the spectre of deflation and may point to future economic weakness. The Chinese economy is slowing; this is acknowledged by Chinese policy makers, along with the need to restructure and rebalance the Chinese economy. Uncertainty about Chinese growth and official announcements to aim for more ambitious CO2 emission reductions point to sustained weakness of commodity prices and Australia’s terms of trade. News of Europe’s economies is not good as several Euro-zone countries are flirting with recession. The military efforts in the Middle East, along with heightened security measures, will likely drag the global economy down.

The consensus to keep the cash rate at its current level of 2.5% is 71%, down 3 percentage points from September. The probability attached to a required rate cut equals 4% (6% in September) while the probability of a required rate hike has risen to 25% (21% in September).

The probabilities at longer horizons are as follows: 6 months out, the probability that the cash rate should remain at 2.5% fell considerably, from 49% in September to 38% in October. The estimated need for an interest rate increase rose to 56% (42% in September), while the need for a decrease equals 7% (9% in September). A year out, the Shadow Board members’ confidence in a required cash rate increase is up 10 percentage points to 71%, the need for a decrease ticked down to 9%, while the probability for a rate hold dropped to 20% (29% in September).

Note: Mark Crosby did not vote in this round.