Inflation behaving = RBA on hold for 2010

Data this week confirmed that economic activity was not only buoyant through the June quarter, but solid momentum has continued into the September quarter. The consumer, the private sector more broadly, and the stunning return of the trade sector, all contributed to a mid-year return to trend GDP growth. However, a return to trend growth was foreshadowed by the RBA when it rapidly restored lending rates back to its long-run average between October 2009 and May this year.

We remain of the view that the next move is up for the RBA as inflation risks remain firmly tilted to the upside. However, we have again pushed back the timing given the lack of a near-term inflation smoking gun, as our in-house monthly inflation gauge suggests that September quarter underlying inflation remains comfortably within target.

As this 'Goldilocks' situation appears likely to remain for the Australian economy for longer, we are now of the view that the RBA can sit tight at 4.5% for the remainder of 2010.

Inflation behaving for longer

The cornerstone of RBA policy is the outlook for inflation, and the "starting point' is very favourable. The June quarter CPI report saw underlying inflation decelerate further from 3.1%/yr to 2.7%/yr. According to our monthly inflation gauge, the risks are tilted towards another benign outcome for the September quarter. Our preliminary underlying CPI forecast is for a lift of +0.6%/qtr and 2.5%/yr. This is definitely not a smoking gun for the RBA, and we have dropped our rapid-fire post-CPI Nov/Dec +50bp tightening.

From a top-down perspective, we don't see inflation breaching the top of the target band until mid-2011, hence why we have only prolonged the mid-cycle pause, not abandoned the tightening cycle altogether.

Are the retail banks poised to hike instead?

The Big 4 Australian retail banks claim that as bank funding costs continue to rise, they 'need' to lift variable mortgage rates independently of the RBA. While it is difficult to construct a strong case that retail bank adjustments impacts the RBA's decision-making process, this X-factor is affecting OIS market pricing.

There is a short history of retail banks adjusting the variable rate independently of the RBA, a feature we have written about regularly. Retail banks began lifting variable mortgage rates independently from the RBA from January 2008, again from April-July 2008, then widened the mortgage-cash rate margin even further by passing on much less than the 425bp of RBA cash rate reductions in late 2008.

So if the retail banks again lift mortgage rates independently of the RBA, this is merely extending the 'new' paradigm that began in January 2008.

US and Canada - also pausing for longer

Our colleagues in the United States and Canada have incorporated more pauses and delays in their central bank projections given the fragile nature of the US economy and Canada's strong economic ties to it. The Bank of Canada is expected to lift the cash rate to 1% next week and now pause for the remainder of the year. The US Federal Reserve may not be lifting the near-zero Fed Funds rate until late 2011 or could even delay into 2012.

The new cash rate profile

The prevailing cash rate of 4.5% is expected to remain in place until the first quarter of 2011. We had expected uncomfortable inflationary pressure to emerge by now, hence had forecast a much swifter shift into restrictive monetary policy.

Now that inflation is more likely to be an issue for 2011, we have pushed the timing of RBA tightening to next year, and shaved 50bp off our year-end target. We have pencilled in RBA tightening after each quarterly CPI report, for a year-end cash rate of 5.5%.

2011 (%) Q1 Q2 Q3 Q4

Cash: prior 5.25 5.75 6.00 6.00

Cash: new 4.75 5.00 5.25 5.50

Core CPI 2 3 3 3

Source: TD Securities

For the markets?

The fixed income markets are pricing Armageddon: global disinflation forces and broad-based flight-to-quality have slashed global bond yields. For Australia, this rally has gone too far and will correct, although this week's solid data flow has (at last) adjusted the OIS probability of a 25bp reduction by June 2011 from 75% to 40%.

There is clearly a disconnect between fixed income and the currency markets. Fixed in come is pricing in the worse outlook for the global economy, while currency markets are clearly supporting commodity currencies such as the AUD and NZD. As Australia is a solid AAA-rated high yielder, we expect the AUD to remain well supported, and we continue to target $US0.90 for end-September and $US0.88 by year end.