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Australia and NZ - Weekly Prospects 17/3/08

* Ahead of a week absent of top-tier economic data, key indicators in Australia last week signalled that the domestic economy remains robust. Demand for home loans was unexpectedly firm in January and solid gains in employment were recorded in February, helping to push the unemployment rate to a fresh 33-year low. Consumers, however, understandably were less upbeat in March in the wake of the RBA's decision to hike interest rates a further 25bp. The release of the minutes of the RBA's Board meeting on Tuesday will likely signal the bank retains a tightening bias owing to the deteriorating domestic inflation outlook, but that the worsening global growth outlook and increasing volatility in financial markets also are growing concerns.

* In New Zealand, housing market indicators last week pointed to further deterioration in the already shaky housing market in 2008, and January retail sales showed only a small rise. The rise in sales was, however, primarily owing to higher prices rather than increased volumes. Consumers continue to tighten their purse strings given rising petrol prices, falling stock prices, the weakening housing market, and record high interest rates. Furthermore, some domestic banks are passing on to consumers higher funding costs resulting from credit market tightening, even though the official cash rate has remained steady since July.

* Against the backdrop of economic news that has broadly tracked our expectations for current-quarter growth globally, there have been two important market developments this year. First, US credit market stress has intensified. Corporate credit spreads continue widening and risk premia on transactions between financial institutions have risen sharply. Second, commodity prices are on fire. The obvious macroeconomic implication of these events is additional downward pressure on US growth. The squeeze being placed on US household purchasing power adds insult to the injury coming from softer labour demand. The intensification of drags on the household sector from tighter financial conditions and elevated inflation contributed to the recent forecast change, which now sees the US economy contracting next quarter.

* Under normal circumstances, the Fed would view recent market developments as an indication that its inflation-fighting credibility is eroding. But, times are far from normal, as the Fed faces daunting challenges in supporting growth and maintaining the orderly functioning of US financial markets. The Fed recognizes that inflation pressures will eventually dissipate, if the economy experiences a recession in which unemployment rises substantially. The Fed can therefore engage in triage to address its most pressing concern. At the start of last week, the FOMC debate looked likely to revolve around whether to cut rates 50 or 75bp. Now, it seems possible that the Fed may go further than our forecast of a 75bp cut. In either circumstance, it looks likely that the real fed funds rate will move into negative territory quickly as the Fed lowers policy rates below 2% in April.


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