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RBA Holds Rates Steady, Counts on Slowdown

Australia's central bank held interest rates steady at a decade high on Tuesday, citing growing evidence that past hikes were working to cool demand and curb inflation in the long run.

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The Australian dollar dipped and bill futures priced in less risk of further tightening, after the Reserve Bank of Australia left rates unchanged at 7.25 percent for its fourth straight policy meeting.

"While the inflation outlook remains concerning, the board's assessment continues to be that demand growth will be moderate this year," RBA Governor Glenn Stevens said in a brief statement. "The most recent flow of information has given additional support to that assessment."

Data on Tuesday showed manufacturing activity contracting at its fastest pace in three years, while sales of new homes fell 5 percent in May as high borrowing costs scared away buyers.

Retail sales have been basically flat for the first four months of the year while the pace of mortgage lending had slowed to lows not seen since a recession in 1991.

The RBA also noted some easing in the tight labor market after employment fell in May for the first time in 19 months.

All of which should help moderate inflation over time. Core inflation hit a 17-year high of 4.2 percent in the first quarter, uncomfortably far above the RBA's 2 to 3 percent target band.

"They're still concerned about inflation because of the pressure from commodity prices, but they seem more confident that a slowdown in activity is underway," judged Kieran Davies, chief economist at ABN AMRO. "As long as that slowdown continues, they should remain on hold."

That was good news for Australia's heavily indebted households, smarting under the rising costs of fuel, food and mortgages.

Interest rates are front page news in a country where owning a home is a national obsession and total mortgage debt amounts to almost A$1 trillion (US$961 billion), the same as the annual output of the entire economy.

Vitriol

Such has been the anger among homeowners that one daily newspaper launched a series of personal attacks on Governor Stevens, accusing him of betraying working families.

The vitriol seems to have touched a nerve at the central bank which has gone on a charm offensive, portraying Stevens as a guitar-playing, church-going father of two who loves to fly light planes for the peace and quiet it brings.

It has also helped that the RBA has not raised rates for the past four meetings and most analysts believe it can hang fire from now on. A Reuters poll of 24 economists last week found 17 thought rates had peaked.

Not only are financial conditions tight in Australia but surging living costs and record petrol prices are whittling away household spending power.

The local share market has also put in its worst performance in 26 years, one reason household wealth fell by A$160 billion in the first quarter alone.

"The sharp slide in share market wealth, together with rising petrol prices and other living costs, has been doing part of the Reserve Bank's job in slowing down the economy," said Craig James, chief equities economist at CommSec. "The good news is that with other factors reinforcing tight monetary policy, the Reserve Bank is more likely to stay on the interest rate sidelines."

But not all is weakness. The labor market remains strong with job vacancies at record highs. Sizeable tax cuts also come into effect from Tuesday, adding around A$30 a week to the average pay packet.

Most importantly, huge price increases for iron ore and coal, Australia's two biggest exports, could boost the country's terms of trade by 20 percent this year, delivering rich pickings to profits, dividends, wages and tax receipts.

"If the tax cuts and the windfall income gains from the terms of trade are spent, growth could pick up toward the back end of 2008," said Matthew Johnson, a senior economist at ICAP.

"Better growth, in an environment of already elevated inflation and tight capacity, will draw the RBA back into the fray seeing them deliver another tap on the breaks toward the end of the year."