Australian Central Bank Considered May Rate Hike

Australia's central bank actively considered raising interest rates earlier this month as inflation was uncomfortably high, minutes of its May policy meeting showed on Tuesday, sending the Australian dollar to 24-year highs.

The Australian dollar climbed to 0.9582 against the U.S. dollar while bond futures slipped as the market priced in more risk of a further rise in interest rates in coming months.

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The Reserve Bank of Australia's (RBA) policy-making board ultimately decided to leave its key cash rate unchanged at a 12-year high of 7.25 percent at its policy meeting on May 6. But minutes of the meeting suggested the decision was a close one.

"Members spent considerable time discussing the case for a further rise in the cash rate," the minutes showed. "But on balance, given the substantial tightening in financial conditions since mid 2007, and the extent of the uncertainty surrounding the outlook, the Board decided that it was appropriate to allow the current setting of monetary policy more time to work," the minutes showed.

Still, the central bank warned that if rates were to move in coming months it would be upwards.

"Should demand not slow as expected or should expectations of high ongoing inflation begin to affect wage and price setting, the outlook, and stance of policy, would need to be reviewed," the minutes showed.

Core inflation accelerated to a 17-year high of 4.2 percent in the first quarter and the RBA expects it to stay above 4.0 percent for much of 2008, only coming back within its 2 to 3 percent target band by late 2010.

"The fact they are still debating whether to hike tells you where the RBA sees the risks for inflation and interest rates -- to the upside," said Michael Blythe, chief economist at Commonwealth Bank.

The Importance of Inflation

That sober message was not what many in the market had been hoping for. Bond and bill futures had recently been toying with the idea of rate cuts by year-end.

But the minutes made it clear easing was not on the agenda. "Board members noted the importance of reducing inflation if Australia was to avoid a prolonged period of economic difficulty," the minutes showed.

To achieve this outcome a significant slowdown in domestic demand was needed, and there had been some evidence that this was happening.

Looking ahead, the board saw powerful opposing forces working on the economy. On one hand a slowdown in global growth, strains in world financial markets and tight domestic financial conditions were working to moderate demand.

But there would also be a stronger than expected boost to Australia's terms of trade from huge rises in prices of coal and iron ore, its two largest export earners.

Indeed, the minutes showed the RBA expected a 20 percent boom in the terms of trade -- what Australia gets for exports compared to what it pays for imports -- this year.

This could boost national income by 3 to 4 percent, providing extra stimulus at a time when the central bank wanted a substantial slowing in the economy.

"Such a boost to incomes could reverse the current slowdown and leave the RBA back where it started -- having to tighten to slow things again," warned CBA's Blythe.