RBA to keep its powder dry

With the Australian economy looking suspiciously like it is already in recession, the Reserve Bank has a tough job on its hands. It needs to get its approach to monetary policy just right as it juggles deteriorating economic conditions and higher than expected inflation figures.

The issue is that there is always a lag effect associated with any policy decisions, so Governor Glenn Stevens is under pressure at the moment to pull the right levers to support the economy at just the right time. He also needs to consider the implications of any more of Mr Rudd's fiscal policy measures. There is potential for a third stimulus package in this year's Federal Budget which will be announced on May 12, one week after the RBA meets.

There were two key pieces of economic news out this week which will influence the outcome of the RBA's May 5 meeting. The International Monetary Fund released some updated 2009 forecasts which paint a grim picture for Australia. The IMF believes that the Australian economy will deteriorate even further and contract by a massive 1.4 per cent this year. Unemployment is likely to rise to 6.8 per cent this year and then reach 7.8 per cent in 2010. This compares to the IMF's forecast for global growth which is predicted to fall by only 1.3 per cent in 2009.

There was also some mixed inflation data for the March quarter out this week. Figures from the Australian Bureau of Statistics showed that core inflation increased by 1.1 per cent since the December quarter. This was surprisingly high and represents an annual increase of 4.15 per cent. It shocked economists who were expecting an annual increase of 2.9 per cent. The market watches the core inflation figure because it presents a clearer picture of inflation as any volatile swings in prices are removed.

Before the ABS figures were out, many market participants had been forecasting a cut of 25 basis points in May. However, the higher than expected inflation data means that the RBA is most certainly going to sit tight at its next meeting.

Analysts are now expecting the bank to take a ‘wait and see' approach. Inflation tends to drop significantly during recessions, so the bank will probably wait for the June quarter data before it considers moving again. Going forward, the market is predicting that the official cash rate will eventually drop from its current level of 3 per cent to 2 per cent by Christmas. Future rate cuts are likely to be small and more spread out as the economy weathers the storm during the remainder of the year.