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RBA: cash rate unchanged for third straight month

Cash rate left at 7.25% as expected

As was widely expected, the RBA today announced an unchanged cash rate at 7.25%. This is the third straight monthly meeting at which the RBA has been inactive on the cash rate target. The expectation of unchanged policy was unanimous among local market economists. Also, futures market pricing had implied a near-zero probability of a rate hike today. We retain our forecast that the RBA will leave the cash rate unchanged for the remainder of 2008 but, with the RBA forecasting inflation above target until 2010, the risks remain tilted towards a higher, not lower, cash rate.

Today's commentary announcing an unchanged cash rate delivered no surprises - in fact, the wording of today's statement is almost identical to what the bank said back in early May, when the cash rate also was unchanged. One material difference from the May statement is that the RBA this time highlighted the strength of the labour market, which is not new information - employment has been booming for two years now. Also, the statement referred to the weakening in credit growth as "significant". As we suspected when the RBA's new communication regime was put in place, RBA officials appear to be having difficulty finding new and imaginative ways to say "rates on hold".

The RBA once again highlighted the "opposing forces" at work in the economy. On the one hand, growth in domestic demand has cooled, in part owing to a tightening in credit conditions and higher interest rates. In particular, the RBA's commentary today highlighted recent data showing significantly weaker growth in credit and softer household spending. On the other hand, however, the forces driving the slow down in domestic spending are being offset to some extent by the soaring terms of trade, which is sending a powerful income pulse through the arteries of the economy. Also, officials indicated that while conditions offshore remain difficult, there has been some improvement.

Once again, the RBA hinted that the risks to the growth and policy outlook are not two-sided. The dominant risk appears to be that officials are anxious about whether domestic demand growth will slow to the extent expected. In our view, the boost to national income from the rising terms of trade, when combined with the stimulus from the generous personal income tax cuts paid from July and still low unemployment, could trigger a rebound in domestic demand in the second half of 2008. This is despite sub-trend growth in the global economy. RBA officials still want to see a "significant" slowing in domestic demand growth in order for inflation to begin its long journey back into the RBA's 2-3% comfort zone.

The other material risk is that the persistence of elevated inflation may become embedded in higher consumer and business inflation expectations which, in turn, could lead to higher wages and prices. Thus far, wage pressure has been contained, but there is significant industrial disputation underway in industries as diverse as airlines, education, the building trades, law and order, and medicine. Most of the workers' agitation is over their demands for wage rises to compensate for high and rising food and energy prices. These are the potential sources of cost-push inflation that RBA officials appear to be concerned about.

One thing is clear - with inflation tracking well above the RBA's target range, and with it likely to stay there for an extended period, rate cuts any time soon are out of the question, at least in the absence of material adverse shocks from offshore. Domestic demand growth's failure to slow in line with RBA expectations, rather than an elevated inflation print, is the most likely candidate as a trigger for further policy tightening. Indeed, with energy and food prices rising sharply, high inflation readings in coming quarters are a given. In terms of pressure points, there is most uncertainty about the outlook for domestic demand - the key data points to watch for policy guidance, therefore, are retail spending, demand for home loans, and the consumer and business confidence readings.

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