US slump a major rates challenge for RBA

The challenge facing the Reserve Bank in setting interest rates in early 2008 just got a lot tougher. At a time when most domestic indicators point toward the need for higher interest rates in the face of increasing inflationary pressures, the international picture suggests the opposite.

In the US, poor housing construction figures, a sub-prime inspired $10 billion loss announced by Merrill Lynch and Federal Reserve chairman Ben Bernanke’s downbeat assessment of the economy are the latest ominous pointers of an economic slump.

While job creation surges unabated in Australia, recession in the US appears very likely if it hasn’t already arrived. Housing construction is dropping off, house prices are falling, and consumer confidence and the jobs market appear to be waning. Bernanke’s statement to Congress that the Fed is ready for "substantive additional action" is being interpreted as a 0.5 percentage point rate cut coming at the next Fed meeting at the end of the month.

The combination of quick and significant rate cuts and a government rescue spending package foreshadowed by President Bush overnight appear to be the only hope of preventing a hard landing in the US economy that would hit the world economy hard – and it may be too late.

This means further rate rises may not be needed in Australia and may turn out to be damaging if, later in the year, the economy is pulled back by a worldwide slowdown. But the RBA has to be sure that, above all else, inflation is kept in check.

Another 20,000 jobs were created in December and the unemployment rate dropped back to 4.3 per cent. Yet official rate rises in the second half of 2007 have already dampened the housing sector. Consumer confidence has fallen sharply in the face of banks pushing up home loan rates separate on top of expectations that the RBA will take its own rate action next month.

On balance, the chances of a 0.25 per cent rise in rates coming on top of banks’ recent rises have reduced. But a February rate hike hangs in the balance as we await quarterly inflation figures due in the coming week, critical to the RBA’s difficult decision. A further rise in underlying inflation will prompt a lift in rates, but would add to risks of downturn later in 2008.

Infochoice.com.au