Could tomorrow’s rate rise be bigger than expected? Economy round-up

As you read this, it is more than likely the Reserve Bank of Australia is deciding to announce a 0.25% interest rate rise tomorrow – and having a good hard think about whether to follow up with another rise next month.

Although there is general consensus that we will see another rate rise before the middle of next year, opinion is divided on whether that second rise could come as soon as December.

Westpac is probably the most prominent voice backing rate rises tomorrow and again in December, a view it says is justified by last month’s stronger than expected retail trade and new housing approval figures.

Westpac’s prediction that the RBA will raise rates twice in two months – or even the more popular view that we will see another rate rise in February or March next year – raises an obvious, but largely unasked, question – if two rises are warranted, why wouldn’t the RBA deliver them both in one go by lifting rates by 0.5%?

According to Westpac senior economist Huw McKay, there is an extremely low – but not zero – chance the RBA could lift rates by 0.5% tomorrow.

“That would be a startling result,” McKay says. “Central banks tend to try and reduce volatility from their own movements rather than creating it. Over time, experimentation here and overseas has found that a 25 point move gives the best balance between not creating too large a ripple (and) having it significant enough to have an affect.”

In short, the reason the RBA is unlikely to raise rates by 0.5% tomorrow is because nobody is expecting it to do so. A surprise 0.5% hike would send a signal to markets and consumers that the RBA perceives inflation to be such a problem that drastic action is required.

The risk, from the RBA’s point of view, is that this could cause consumer and market sentiment to plummet, a consequence that could mean the effective cut delivered would be greater than the 0.5% intended.

By contrast, McKay says, back-to-back 0.25% rises would be unlikely to scare the horses, particularly since the RBA has some history of doing so.

“We haven’t seen many 50 point hikes, but we have got a reasonably recent precedent for back-to-back 0.25% moves from late 2003, when the RBA was very concerned about the housing boom and very strong credit growth. This time that isn’t that concern, but we do think the conditions for back-to-back rises are in place,” McKay says.

All that isn’t to say that a December rate rise wouldn’t have a few somewhat dramatic consequences. In particular, because the markets haven’t priced in a high likelihood of a December rise, a lift could see a sudden upswing in the Australian dollar and see it well on the way to hitting US96c by March 2008 as some have predicted.

On today’s markets, however, the Australian dollar is worth US92.18c at 11.30am, only mildly up on last night’s close of US92.04c. At the same time the S&P/ASX 200 looks set to recover much of the value it lost yesterday, trading up 1% to 6647.3 at 11.30am.