Economics 101 tells us that high interest rates discourage
borrowing, spending and investment, while at the same time, savings are
encouraged. As this behaviour permeates
through the economy, firms will have greater difficulty passing on higher prices
(dampening inflation) and could even force firms to discount selling prices
(deflation) to maintain market share. This in time leads to a lower
inflation rate than would otherwise be the case.

The interest rate rise today resulted from the RBA previously
under-estimating actual inflation in the first
half of 2006 which no doubt forced it to revise its forecasts for
inflation higher. Indeed, without the
interest rate rise today, the RBA forecast for inflation would be inconsistent
with its 2-3% target. It had to
hike.

In hiking interest rates for a seventh time since early 2002, the
RBA is aiming to slow the growth in borrowing, to dampen spending and investment
and to encourage us all to save. This
will happen to some extent, but the difficulty for the markets and the RBA is
judging whether the response to the rate rise today (and the prior six hikes)
will be sufficient to ensure inflation eases back into the target range over the
year ahead or whether the inflation forces
working through the economy are still stronger enough to offset the higher
interest rate settings.

Reading between the lines of the RBA Statement, it is clear that a
further rate rise is more likely than not.

The interest rate rise is also aimed more or less to offset the
stimulatory impact of the income tax cuts that were paid on 1 July, the strong
global economic conditions and concerns that the labour market skills shortages
will spill over to higher wages as the economy continues to expand. The market judges that the move today is
unlikely to be enough to see inflation fall back to within the target band. The money market futures have an 80% chance
of a further 25 basis point interest rate hike in late 2006.

This looks a fair bet, although any repeat of
the fiscal largesse in the run-up to the election at the end of next year will
risk even more rate rises as the RBA grapples with an inflation
problem.

Peter Fray

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