Australian & New Zealand Weekly

Week beginning 21 January 2008

• Australia: Jan 23 CPI to confirm Feb rate hike.
• US, UK, EU: downward revisions to rate forecasts.
• RBNZ: inflation risks build but no rate change likely Jan 24.
• US data lull ahead of 'Fed week'
• Key economic & financial forecasts.

Australia - CPI to Confirm Rate Hike

We are forecasting the RBA's trimmed mean measure of the CPI for the December quarter to print 0.9% when it is released at 11:30 on Wednesday, January 23 next week. That would push annual core inflation to 3.4% - territory the RBA has never been in before.

Since the early 1990s, when inflation collapsed following the recession, core inflation has only exceeded 3% on two occasions - in 1995 (3.13%) and 2001 (3.3%).The 2001 episode was the lagged effect of the introduction of the GST in July 2000.

We don't expect there would be too much debate around the Board table if that number eventuates.

A 0.8% result would be more problematic because it could be argued that since the last two quarters registered 0.9% there was encouraging evidence that inflation had peaked. Concerns about global growth could then be used to justify a no move decision.

At 0.8% the decision would come down to whether the Governor in particular actually wants to raise rates. It will depend on his instinct as to whether it is "dangerous" to raise rates given the current global environment or whether domestic pressures are such that more insurance against unrelenting upward inflation pressures is required. My view is that a drop from 0.9% to 0.8% would be unconvincing and the lessons from the cost of the inaction in 2007 H1 will dominate.

More specifically it will depend on how strongly the Governor supports the view that the current global easing of liquidity will see capital move to those regions offering the best likely returns - specifically, the emerging economies - providing further direct and indirect stimulus to our own economy.

Today we have the reverse situation to the Asian/Russian crisis of the late 1990s. At that time the Fed eased financial conditions to address global concerns, but because the US economy was still strong the liquidity stayed in the US eventually boosting the 'dot.com' bubble. This time liquidity is likely to flow to these regions further boosting their prospects and maintaining pressure on Australia's inflation problem.

Clearly there are risks to our 0.9% forecast. As we have discussed before, there are seven large components that usually figure in the trimmed mean and explain around 50% of the trimmed mean. They are: house purchase costs (11.3% of the trimmed mean); rents (7.6%); motor vehicles (6.6%); deposit and loan facilities (6.1%); restaurant meals and take away (6.6%); other financial services (4.7%) and telecommunications (4.3%).

We expect that the risks to our estimate of the first three components are to the upside and are balanced for the remaining four.

House purchase costs have recently been on an upward trend and anecdotal evidence indicates that while discounting of new houses has ceased, raw material input costs are now being passed on.

We have assumed no further increase in rental cost inflation despite a clear uptrend and ongoing evidence of accelerating rents.

Deposit and loan rates should continue to increase as the liquidity stresses in the December quarter forced intermediaries to offset some of their higher funding costs with higher retail lending rates. However, the major effect here should come in the March quarter when the banks raised existing mortgage rates.

Even if we assume unrealistic lows for each of these three components we still cannot see core inflation printing below 0.8%. Of course, if our conservatism on these components is misplaced, the trimmed mean could easily print 1%.

The examples of the surprisingly low prints for 2006Q4 and 2007Q1 should not be forgotten but they represented an earlier stage in the housing cycle and stable funding conditions for deposit taking institutions. As noted, rents and housing costs represent key reasons for our "high" estimates.

Other factors that the Board would need to weigh up in the event of a difficult decision should core inflation print "only" 0.8% are:

• the liquidity crisis was much more severe at the time of the last Board meeting on December 5. The minutes indicated that the Board would have tightened immediately had it not been for the liquidity crisis and the reasonable expectation that the banks would raise existing mortgage rates. Breakeven increases in excess of 0.25% would have been expected by the Board at that time. In the event the banks "blinked" and by the time they did move, liquidity conditions had improved and the weighted average rise was "only" around 0.14% - significantly less than the Bank would have expected on December 5.
• global growth prospects have definitely deteriorated since the last Board meeting but (as discussed) liquidity conditions have improved markedly. At the peak of the crisis in August and October, USD LIBOR was 80 to 100bps above the estimated risk free curve (adjusted for Fed funds expectations rather than flight to quality overshoot). Libor is now around 25bps above the risk free rate.

The domestic activity data since the last Board meeting remains remarkably resilient to the rate hikes in August and November and the credit crisis.

• November retail sales jumped by 0.8% to increase annual growth from 7.7% to 8.1%.
• the annualised level of dwelling approvals in November markedly exceeded underlying demand for the first time since 2003.
• the unemployment rate in December fell back to 4.3%, following solid jobs growth of 20,000 - the 14th consecutive monthly gain in jobs.
• inflation expectations (watched closely by RBA) jumped sharply in January.
• annual credit growth surged to 16.2% in November although this is partly due to businesses moving borrowing back to domestic institutions as alternative sources such as offshore banks and capital markets have tightened.

The only disappointing data was the 8.3% fall in the Westpac Consumer Sentiment Index - a "typical" response to the rate hikes which were initiated by the Australian banks (average fall in Sentiment following the last six rate hikes has been 9.7%).

Markets have been overwhelmed by the deteriorating growth prospects in the US, Japan and Europe. But we are yet to see any convincing evidence of spillover to developing economies. Our own Global Leading Index which includes the prospects for the developing world continues to hold up in stark contrast with the OECD equivalent (see figure)

Anecdotal evidence of 50% to 70% price rises in the next round of bulk commodities contracts and recent rises in some base metal prices point to Australia's commodity boom continuing into 2008.

For the RBA, the ongoing risk is that it has underestimated the boost to demand from the commodities boom and associated fiscal stimulus. It may also have overestimated any likely addition to supply of labour from the recent (some to be reversed) labour market reforms.

There is a respectable argument that a 2% to 3% target band for inflation in an economy which has enjoyed such a large prosperity dividend as Australia has received with its 45% boost to the terms of trade just cannot be achieved and the RBA should admit defeat.

However, I doubt whether the RBA will be prepared to accept that position for some time to come.

Downward revisions to US; Europe and UK rates

While we have not changed our RBA and RBNZ policy forecasts or AUD and NZD currency forecasts, we have revised down the profile for the US Federal Reserve; European Central Bank and Bank of England.

In our mid December Monthly report we assessed the low point of Fed rate cycle as 4% in January 2008. That has now been revised down to 3% by mid 2008. We confidently expect a 50 bp cut from the Fed on January 29 and expect there will be sufficient evidence from a slowing consumer and weakening labour markets to justify a further three cuts of 25 bp's over the next three Fed meetings.

Stubbornly high inflation; solid global growth and strong corporate balance sheets are likely to avert the need for the Fed to push rates down to the 2% levels that are currently favoured by the markets. However, the estimate that real rates will bottom out around 0.5% (above previous "recession" levels) and that the easing cycle will be a relatively short at nine months puts the risks to our call on the downside.

Further, we are not in the camp that expects a relatively quick recovery in the US. The pervasive impact on US households of tight credit and the necessary further 8% to 10% fall in house prices is likely to constrain the pace of any recovery so we expect a period of at least 12 months of flat rates.

We have also factored in some modest cuts (from 4% to 3.5% by years' end) in the ECB's repo rate profile. With the over valued currency and slowing growth likely to take the edge off inflation in the European region, the ECB will have some scope to ease rates modestly from around mid year, particularly once US rates fall to 1% below the ECB's current repo rate of 4%.

We have sharply revised down the profile for rates in the UK. Unlike Australia which benefits from its exposure to high commodity prices and resilient growth in the Asian region, the UK economy appears to be overexposed to the financial services sector and an associated "bubble" in its housing and commercial property markets. Falling house prices and a sharp downturn in its financial services sector are likely to expose the need for the Bank of England to move decisively on interest rates. We have lowered our target rate for the Bank of England's base rate to 4.5% by year's end.

Bill Evans, Chief Economist

Australia: Data Wrap

Dec TD-MI inflation gauge

• The TD-Melbourne Institute inflation gauge jumped 0.6% in December following a 0.3% rise previously, the strongest monthly gain since July. The main sources of price rises cited were petrol, deposit and loan facilities (some pass through of higher funding costs with more to come in Jan), rents and overseas holidays. Partially offsetting price falls were seen in seafood and confectionary. With a 0.3%mth rise from the previous year dropping out, annual growth in the gauge rose to 3.7%yr from 3.4%, the highest since December 2006.
• With the December jump much greater than that three months prior in September, 3mth growth jumped to 1.11% from 0.69% previously. The mid-month of the quarter read on the gauge has the better historical correlation with the quarterly headline CPI pace, and that 3mth pace was 0.69% in November. However, the mid-mth of the quarter gauge pace proved to be a significant overestimate in Q3 and for Q4 we expect it to be an underestimate. The fact that the gauge pace rose significantly in December reinforces our view of a stronger headline CPI pace in Q4.
• Prices rose in 33 expenditure classes (vs 32 prev), fell in 5 (vs 13 prev) and were unchanged in 52 (vs 45 prev), giving a net balance of 28 price rises (vs 19 prev), the highest since July. Also, the trimmed mean of the inflation gauge rose 0.5%mth in December (vs 0.4% prev), the fastest since July, with 3mth annualised growth rising to 3.9% from 3.3% previously. This trimmed mean pace and strong breadth of price pressures reinforces our view of a similarly strong RBA core CPI in Q4 to Q3.

Dec ANZ job ads

• Total job ads rose 7.1% to a new record high for the series after a 0.7% rise previously. Trend growth accelerated to 1.6%mth from 1.4%, the fastest since June. Annual trend growth eased to 30.4%yr from 31.9%yr previously, but remains well up from its low of 19.8%yr in Nov 2005.
• Although off its highs, the historically strong pace of trend growth in job ads remains consistent with jobs growth at a 3%-plus annualised pace through to May 2008.

Nov housing finance

• Housing finance increased in November, despite the Reserve Bank lifting interest rates in August and again in November and despite unsettled credit market conditions.
• The number of loans to owner-occupiers increased by 4.0% in the month. New lending was not as strong, rising by 1.5%. The wedge reflects the burst of refinancing in the month, up 10.6%.
• We expected demand for housing finance to weaken in the face of higher borrowing costs. However households, supported by sizeable income gains flowing from buoyant labour market conditions, have so far been able to absorb the impact of rate rises.
• We still see the risk of housing finance weakening early in 2008 as borrowing costs increase further. Commercial banks have now passed through higher borrowing costs and we anticipate a February RBA rate hike.

Jan Westpac-MI Consumer Confidence

• The Westpac-Melbourne Institute Index of Consumer Sentiment fell by 8.3% in January from 112.5 in December to 103.1 in January.
• This is a fairly typical response to an increase in existing mortgage rates. The average fall in the Index in response to the previous six rate hikes has been 9.7%. This time the increase did not come as a result of the RBA raising its overnight cash rate but directly from the banks as they sought to recover some of the additional funding costs associated with the global credit crisis. Unlike a 'normal' rate increase associated with the RBA of 0.25%, the average increase on this occasion was around 0.15%.
• Consumers have also been battered by a series of other unsettling news. Firstly, media reports have pointed to a possible follow up rate hike from the RBA in February if inflation pressures are seen to persist. Secondly, while global credit conditions appear to have improved since the beginning of the year, media emphasis has been on the probability of a recession in the US which would undoubtedly have unnerved consumers.
• Consumers have experienced a 10% increase in petrol prices over the last 2 months. News on the sharemarket has also been discouraging. The Australian market fell 10.1% between the Dec and Jan survey weeks.
• At 103.1, the Index is still pointing to a majority of optimists over pessimists. However, the Index is now down 16.8% from its May 2007 peak; is 5.9% below the level of January last year and 10.5% below its average for 2007.

Dec labour force

• The December labour force data was solid as expected. Employment rose 20.1k (consensus 20k) after a 47.6k rise previously, the 14th consecutive gain. Trend growth is now 2.6%yr.
• Full-time employment rose only 6.3k, but trend growth remained strong at 3%yr. An accompanying 0.1ppt pullback in participation from a record high to 65.2% reinforced, taking the unemployment rate back to 4.3% from 4.5%.
• Lead indicators of labour demand remain strong, consistent with annualised jobs growth of at least 3% through 2008H1. This should maintain downward pressure on the unemployment rate through at least 2008H1, perpetuating the risk of wage pressures adding to the rising inflation pulse.

Jan MI inflationary expectations

• Consumers' inflationary expectations rebounded to 4.4% in January after falling from 4.4% to 4.1% in December. This reinforced the strong uptrend in expectations apparent now since January 2007.
• The trend level rose to 4.42% in January from 4.30% in December, a new record high since this data commenced in 1993. Of even greater concern, the median expectation of managers and professionals spiked to 4.9% in January from 4.1% in December, continuing their strong uptrend from a low in February 2007. The trend rose to 4.66% in January from 4.49% in December, a new record high since this series commenced in 1995.
• The RBA's November SoMP described inflationary expectations as remaining "relatively high" noting that this series "averaged 3.8 per cent over the three months to October, well above the average expectation over the inflation-targeting period." That three month average has now risen to 4.3%, even further beyond the average since 1994 of 3.1%.

Jan Westpac-MI unemployment expectations

• Consumer unemployment expectations rose 1.9% in January to 113.90 after a 4.5% rise previously. Their uptrend since July continued, suggesting some faltering in labour market opinions from recent highs. However, their deviation from long run levels remains sufficiently negative (-9.3%) to imply a resilient and still firm outlook for full-time jobs growth at around its current 3%yr pace into 2008Q2. Further weakness from here however would point to risks of a softening in the full-time jobs growth outlook around mid-2008.

Q4 International trade prices

• Export prices fell 0.6% in Q4 after a 3.0% fall previously, with falls in metal ores, non-ferrous metals and coal, and valuation effects from a higher AUD, partially offset by increases in gas and petroleum products.
• Import prices rose 0.2% in Q4 after a 0.8% fall previously. Petroleum prices rose 13.9%, near our expected 13.3% rise, and food prices pulled back 2.1%. Core import prices (ex-food and petroleum) saw a slightly lower than expected currency benefit pass-through, falling 1.8% (we had -2.0%) in a quarter where the import weighted AUD TWI rose 3.2%.
• The data has no implications for our CPI forecast - the link between import prices for consumer goods and the CPI is poor.

Round-up of local data released last week

New Zealand: The Week ahead & Economic Wrap

Inflations risks but no change

All eyes will be on the RBNZ this week, with very little on the domestic data front.

The decision on January 24 seems a foregone conclusion - there will be no change in the OCR. All attention will be on the tone of the few paragraphs that Dr Bollard and team pens. There is plenty to talk about. The RBNZ will refer to inflation concerns surrounding tighter capacity constraints, higher oil prices, risk of additional fiscal stimulus, and upcoming one-off government charges. But the housing market has been correcting a touch faster than the RBNZ was anticipating and there has been increased uncertainty surrounding the international outlook. The RBNZ will likely conclude with the same sentiments as in the December MPS: “We believe that the current level of the OCR remains consistent with future inflation outcomes of 1 to 3 percent on average over the medium term, based on the information to hand at present”.

In recent times, the RBNZ has been good at signalling their next move. If they deliver a no-change and OCR consistent message, we will push our rate hike call into Q2 when international concerns may have abated.

There are major counter forces operating on the economy. Contractionary influences include higher interest rates, higher petrol prices, and the housing correction. Major stimulus is coming by way of very strong wage growth, a wall of dairy cash, and the carrot of tax cuts / fiscal stimulus. In our minds the second half of 2007 was supposed to represent a 'pothole' in growth (as petrol and interest rates constrained activity before the Terms of Trade and fiscal stimuli kicked in). Last week's release of the Quarterly Survey of Business Opinion showing capacity constraints and labour tightness approaching record levels in Q4 2007 suggests the pot hole may well be small. While those in the cities are likely to be facing difficult times, the provinces will be booming. The Reserve Bank can only work on averages.

The main uncertainty for domestic monetary policy revolves around what sort of international environment NZ will be facing. Despite the current carnage on global equity markets, we expect the Australian and Asian real economies to be relatively unscathed by the US slowdown. If that is the case, NZ has an inflation problem and will require higher interest rates (we are picking two hikes this year). If the global economy and NZ commodity prices are contaminated by a weak US economy, interest rate hikes will not be necessary.

Evidence of the inflation problem we have been forecasting emerged last week as CPI inflation surged through the top end of the RBNZ's 1-3% target band in Q4 2007, rising from 1.8% to 3.2%. We think annual CPI is heading towards 4% in 2008. Core inflation measures presented a mixed bag, but remain persistent.

While the high starting point for inflation will have the RBNZ short of breath, it is the outlook that is the worry. Inflation seems to be all pervasive:

• The economy is very capacity constrained (with capacity utilisation at 92.0% approaching its historical peak level, and reported difficulty of finding labour surging);
• There is substantial pipeline food price inflation;
• Energy and transport costs have been rocketing; and
• Business costs are rising rapidly through employment costs (high wage growth, Kiwisaver contributions, an additional weeks paid leave), transport costs and rents.

Last week retail trade survey showed nominal sales in November surged on the back of higher petrol and food prices. November's increase follows a dip in October. The December month RBNZ credit card billings on Thursday (1500 NZT) will give us a guide to retail sales over the Christmas period. We expect some growth in billings from November suggesting Christmas retailing was reasonable, but far from spectacular. Meanwhile, the December month manufacturing PMI data (Thursday 1200 NZT) is expected to show a healthier situation than many perceive the sector to be in. A booming Australian economy and reasonable cross exchange rate is expected to see the PMI index at a level consistent with moderate expansion.

Round-up of local data released last week

Data previews

Aus Q4 PPI

Jan 21, Last: 1.1%, WBC f/c: 1.2%

Mkt f/c: 1.1%, Range: 0.6% to 1.5%

• The Q3 PPI rose 1.1%qtr and 2.4%yr. Non-core items added less than expected (0.3ppt) with strong food but lower fuel. Core import prices fell (-1.8%) with a strong AUD, but strong core domestic ex-construction prices (1.7%) saw overall core PPI jump 1.1%qtr.
• In Q4 we expect a further fall in core import prices (-2.0%) with AUD rise, but another solid domestic core ex-construction (0.9%) amidst solid demand, and a pick up in building construction prices (1.5%). This gives a 0.8%qtr core PPI. With food (1.5%) and petroleum (12.1%) higher, the total PPI should rise 1.2%qtr, boosting the annual rate to 3.4%yr (with upside risk from an even higher domestic core).

PPI: qtly food, fuel, domestic core pressures

Aus Q4 CPI

Jan 23, Last: 0.7%, WBC f/c: 0.9%

Mkt f/c: 1.0%, Range: 0.7% to 1.3%

• Headline CPI f/c is 0.9%qtr & 3.0%yr (vs 1.9%yr prev). Petrol adds 0.28ppts, rents add 0.09ppts, house purchase adds 0.09ppts & depo. & loan facilities add 0.06ppts. Pluses in transportation (petrol), housing (rent, house purchase), food (most items), fin. & ins. services (rate hikes), recreation (holidays), h/hld contents. Minuses in health (PBS effect) & apparel.
• Avg RBA core CPI f/c is 0.9%qtr (0.88% trimmed mean) lifting annual to 3.4%yr from 3.0% (highest since 1991). 3 of 7 key items that account for half of trimmed mean have f/c's with upside risk (house purchase, rents, depo. & loan facilities); Other 4 have balanced risks. Core CPI pressures likely to be broadly based overall.

CPI inflation: RBA core to hit 3.4%yr

Aus Nov Westpac-MI Leading Index

Jan 23, Last: 5.5% annualised

• The annualised growth rate of the Westpac-MI Leading Index of economic activity, which indicates the likely pace of economic activity 3 to 9 months into the future, was 5.5% in October, well above its long term trend of 4.2%.
• In November the monthly components of the index were generally positive. Dwelling approvals jumped 8.9%. The money supply expanded by a brisk 2.6% and surged by 23% over the year. However, the share market retreated 3.3% as uncertainty weighed on investors. On the international front, US industrial production partially recovered, rising by 0.3% after a 0.5% fall in October.
• We caution that US recession risks and unsettled global credit markets are casting a cloud over the outlook.

Westpac-MI Leading Index

NZ RBNZ OCR review

Jan 24, Last: 8.25%, WBC f/c: 8.25%, mkt f/c: 8.25%

• The OCR will almost certainly remain on hold.
• The statement will be hawkish and mostly devoted to worsening inflation risks. The deteriorating global economic backdrop and the dead housing market will also be mentioned. They may mention credit spreads, which have held 90-day rates at a suitably high level, reducing the need for OCR hikes.
• We expect the crucial last sentence to be "the current level of the OCR remains consistent with future inflation outcomes of 1 to 3 per cent...", signalling an "on hold for the foreseeable future" stance.

NZ OCR and 90 day rate

US Dec existing homes sales

Jan 24, Last: 0.4%, f/c -1.0%, WBC -0.2%

• Existing home sales rose 0.4% in Nov, the first rise in sales after falling for eight months straight.
• Due to the delays with contract exchange, you normally expect a one month lag between the new home sales existing home sales. So the Nov 9.0% plunge in new home sales points to another significant fall in existing sale in Dec. Pending homes sale also fell 2.6% in Nov.
• No doubt the housing correction has further to run, but the sharp drop-off in existing sales during Aug and Sept may have been extended by the credit market turmoil that has now unwound. The NAHB survey edged higher in Nov, and held the gains in Dec, while mortgage applications have steamed ahead over the last few weeks. We are looking for small fall in Dec.

US housing sales

Westpac Institutional Bank
http://www.westpac.com.au

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