Thursday, August 03, 2006

Interest rate rise

The 25 basis points rise in official interest rates to 6.00% announced yesterday by the RBA shows the RBA is concerned about inflation and believes that past increases in interest rates have not yet bitten. Indeed credit growth is rocketing away at about the highest levels for more than a decade. New loans for housing grew at 25% in the year to May. Even ignoring fruit and fuel price increases inflation is drifting out of the RBA's comfort zone of 2.5-3%. The market is also attaching a high probability to a further interest rate hike later this year.

The higher interest rates - and higher fuel prices - will cut into spending and will mean that many Australians will be unable to afford to live as well as they would have expected given the July 1 tax cuts. The RBA however still see the $9 billion tax cuts as having a net stimulatory effect. Indeed it is this effect that might be seen as the villain driving the interest rate hikes.

The RBA are concernmed about strong growth in the world economy - particularly in China and Japan - though there has been lower than expected US growth.

There is also RBA concern with trade unions building price increases into wage demands thereby generating a wage price spiral. Jobs will harder to get as a consequence of the hike. To compensate those on fixed incomes will be better-off and house renters at least won't be worse-off - at least in the short-run.

One suspects that the interest rate hike will hit hardest in the low growth states such as NSW and Victoria - WA and Queensland have resource booms driving rapid growth.

I looked at a number of newspapers this morning and most gave the RBA a tick of approval. There were a few rumblings about possible long-lags in monetary policy effects that might tip slow-growing states into recession though this would be a consequence of recent interest rate tightening generally rather than this single small increase - interest rates have risen 7 times in 4 years.


Bring Back EP at LP said...

I think the RBA is saying we think the next move is again a rise.

Strong commodity prices and a give away budget always meant rates would rise.

underlying inflation has surprised the RBA on the upside.

given the lags involved the next election will be interesting

Steve Edney said...

My Calculations on SFE IB Cash Futures put the market probabilities as:
Sep 14%
Oct 29%
Nov 62%
Dec 71%

hc said...

Steve, These are probabilities of 25 basis point increase at these dates? Is it easy to explain how you get them?

Steve Edney said...

Yes the asusmptions are its based on a 25bp movement (6-6.25), and that the RBA only changes the day after a meeting, which they are of course not obliged to, its just because its customary that's the only time they do.

So IB30day cash futures, pay off on the basis of the average cash rate over a months, from start to end. Therefore the rates are basically a direct expectation of the rate. However we really want the expection between rate moves which are from the meeting dates, so you do a bit of a calculation to seperate this out, sort of bootstrapping out each month from the current cash rate.

Given the assumption of a binary move between 6 and 6.25 its easy to derive then the probability of the two outcomes. This here is the big flaw in the calculation, and why its not worth fdoing past about 3-4 months, after that there should clearly be some other possibilities factored in (higher and lower) but its not possible to get a unique result doing that without making further assumptions.

You could derive 1 day forward rates from the bank bills and bank bill futures, but these markets trade about 12 basis points on average away from the IB futures and overnight indexing swaps market.

Steve Edney said...

Interestingly the market probabilities for future rises have decreased since the announcement.

They now stand at
Sep 6%
Oct 15%
Nov 53%
Dec 58%