Hopes for 2007 rate cuts a little premature

If the government's mid-year fiscal and economic review turns out to be right, we can expect interest rates to stay on hold in the first half of 2007, perhaps even drop back at some stage during the year. It could happen, but don't bet on it.

Treasurer Peter Costello has revealed downward revisions in the growth and inflation forecasts for the current financial year and next. The drag on the economy from drought and severe recession in rural Australia and flat economies in the south-eastern states are the main culprits. It seems a recipe for lower interest rates perhaps late next year.

But the downward revision in economic growth from 3.25 to 2.5 per cent only brings the forecast into line with what we've already seen in the June and September quarters – sluggish growth at just over 2 per cent annualised.

The problem is that this growth performance does not fit well at all with the ongoing boom in the jobs market. Employment growth has shown no signs of slowing and defied predictions all year it would come to an end. It can't go on forever, but while it does, inflationary pressures won't ease considerably and rates can't be relaxed – because consumer spending will remain healthy and constraints in the labour market will remain.

And there are other signs that suggest the picture of a moderating economy is questionable. The Westpac-Melbourne Institute leading index of economic activity, which indicates the likely pace of economic activity over the coming three to nine months, jumped again in October to an annual rate of 5.8 per cent.

The mid-year review's revised estimate for a higher Budget surplus this financial year also raises the prospect of further generous tax cuts next May – it is an election year, remember. This would also help derail the prospects for interest rate cuts in 2007.

Would we have got the third rate rise this year in November if the last round of Budget tax cuts had not piled extra stimulus into an already bubbling economy?

Inflation is now forecast to ease over the second half of the financial year, the Treasurer says, but it is hard to see it falling enough for underlying inflation to settle back to the middle of the 2 to 3 per cent target band – that is what's needed before there can be any talk of rate cuts.