RBA Says Inflation May Limit Rate Room Flexibility

One of Australia's top central bankers on Thursday said the high level of inflation could limit room for maneuver on interest rates, pointing to some caution about cutting rates too aggressively in coming months.

The Reserve Bank of Australia (RBA) is still widely expected to cut rates by at least 50 basis points at its policy board meeting next Tuesday, though Deputy Governor Ric Battellino's comments saw markets trim expectations of a bigger move.

Telling households to beware of too much pessimism, Battellino also said the economy was on track to avoid the recession engulfing many other developed countries.

"The bank has for some time thought that inflation would peak in the second half of 2008 and then fall; accordingly, we have acted pre-emptively in reducing interest rates," said Battellino.

"Nonetheless, there is still a big task ahead to bring inflation down and this could limit room for maneuver on monetary policy," he added.

The RBA slashed its key cash rate by 100 basis points to 6.0 percent earlier this month, the biggest cut in 16 years, even as core inflation was running at a 17-year high of 4.7 percent.

Investors have been assuming rates would be lowered as far as 5 percent by Christmas.

Still, Battellino remained confident that inflation would come down over time.

"While he effectively said that inflation could limit rate cuts, he importantly added that inflation is currently being dealt with," said George Tharenou, an economist at UBS. "On balance, we continue to expect the RBA to continue to cut rates given the deteriorating global growth outlook, highlighted by the global financial market turmoil."

Likewise, while the market trimmed the chances of a 75 basis-point easing next week, it was still implying a half point reduction to 5.5 percent.
     
Side Stepping Recession

Battellino acknowledged that economic growth in Australia would likely be noticeably more subdued in the next two years or so, but said this was a necessary breathing space following above average growth in preceding years.

Many people will be disappointed and unhappy with a year or two of below-average economic performance," he said. "But the truth is that the economy cannot always grow above average and it certainly cannot maintain the pace of the past five years."

Yet he was optimistic that Australia could sidestep a coming global recession, just as it did in 2001.

"That is certainly what we are aiming for, and there is nothing in the data to date to suggest that we are off track," said Battellino.

This argument was in part based on the emergence of China as Australia's biggest trading partner and an expectation it would continue to demand Australian resources for its expansion.

Battellino was upbeat on household finances, noting real disposable incomes had risen by 25 percent in the past five years, exceeding any other developed country.

Income growth was likely to be below average in the next year or two, he said, but argued there was no reason to doubt that it would pick up again afterwards.

Battellino acknowledged that household wealth had been hit by the steep fall in share values this year. He estimated household assets had fallen by 11 percent just since the end of June, to stand at A$245,000 per household.

"While the sharp fall in share prices since late last year is confronting, the thing that needs to be kept in mind is that it was preceded by four years of extremely strong returns," he said.

Battellino noted that the yield on Australian shares was now well above the long-run average and at levels that pointed to strong returns in coming years.

He also argued that house prices in Australia would not fall nearly as far as they have in the United States, in part because there was no excess of unsold, empty homes here.

"It is important not to become too pessimistic because, fundamentally, household finances and the economy more generally remain in good shape," concluded Battellino.

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