February rates decision

by David Taylor

The interest rate forecasting game is a curious one. Some want to test their predictive skills against the Reserve Bank by accurately forecasting whether rates will go up or down, by how much, and at which meeting. Others are on tight budgets and are genuinely anxious about whether they will be able to meet their on-going mortgage repayments. Whichever situation you find yourself in, the hard truth is that you can't predict what's going to eventuate with certainly. You can, however, make an educated guess.

In the case of next month's Reserve Bank meeting, the board will be looking at two main factors - the same two factors it has been looking at closely for over six months now - that is, inflation and global economic growth (Europe growth in particular).

The Reserve Bank does have a charter to follow. That includes maintaining price stability, managing the currency, and looking after the welfare of ordinary Australians - or something like that! The focus on the factors in the previous paragraph is more a 'sign of the times'. In other words, while the bank has objectives to meet, it's clear that by focusing on inflation and world growth (current issues), it's also going to be able to meet the majority of its other objectives.

Last week we had reads on inflation. They were pretty good. Headline inflation came in at 3.1 per cent, while underlying (or core) inflation, rose slightly to 2.6 per cent. While the core rate (the bank's preferred measure which strips out volatility) was still well inside the Reserve Bank's 2-3 per cent target band, it was higher than expected. That means the market had priced in a lower level of inflation in its next interest rate change prediction. As such, the market moved from a rate cut in February being almost a certainty, to a rate cut being likely. That saw the Aussie dollar rise around half a cent against the greenback as investors priced in more yield for Aussie securities.

As far as global growth is concerned, the biggest risks to the downside remain Greece and Italy. Greece has a large debt repayment due in the second half of March. If the country fails to arrange a deal with its private bond holders, and does not receive further aid, it will endure a disorderly default in March. That will send markets into a tail-spin and could substantially raise the borrowing costs for Italy. It could start a very ugly process which could run the risk of producing another credit crunch. But the Reserve Bank's February decision will occur before any of this happens. So, at this point, it remains just a risk.

The end result is that we could get a rate cut in February, but the Reserve Bank is also very well placed to cut rates later if it's warranted by the global economy taking a serious turn for the worse. With rates at 4.25 per cent, it's certainly got lots of room to move. It may also need all that room!

The important take home message at this point is that a rate cut in February is no certainty. We haven't seen a catalyst in Europe to warrant financial panic and the subsequent need for quick domestic stimulus, and domestic inflation is not low enough for a rate cut to be comfortable. So if you have a mortgage, and you're on a tight budget, the most prudent thing to do is assume there will not be a rate cut. That way if there is a rate cut, it'll simply be a pleasant surprise.

David Taylor

Disclaimer

The content in my blog is non advisory, please do not interpret this as advice in any way shape or form. These are just my thoughts and nothing I say should be acted upon.