The Reserve Bank and some of the more hawkish business economists and commentators might rue the day they weighed into the Australian economy with a club.

They might just get what they wanted: a sharp slowdown in economic activity; but they may also get a much sharper slump if the Bank is forced to lift its key interest rate above 7.5%.

There are only two ways the RBA and its mates will get a moderation of inflation, either by slowing the Australian economy to the point where indicators like retail sales start slowing or become static, or by driving up unemployment, perhaps well beyond 5%.

The other way is where the slowdown is imposed externally as, say, China catches cold from the sluggish US and European economies and cuts its demand for commodities. That is improbable, although it looks like the severe snowstorms and bad weather will have a noticeable impact on Chinese growth, exports and possibly inflation for February.

As the AMP’s Dr Shane Oliver warned last Friday, there is a danger of the Reserve Bank raising rates into a slow down. He pointed out that’s what happened in the last recession.

Then there was today’s latest survey of business confidence from the National Australia Bank. It said business confidence suffered its biggest slide since 2001, and its biggest six month fall in a decade. The NAB said the monthly business survey found that business confidence had fallen by nine points in January to minus four, which was its worst reading since the September 11, 2001 terrorist attacks.

The survey said the sharemarket wobbles last month and the RBA’s lift in rates last week by 0.25% to 7.0%, also had hit confidence.

Investment Bank UBS warned this morning that the chances of a “hard landing” had risen in the wake of the RBA’s very hawkish Monetary Policy Statement yesterday.

We now expect the RBA to lift the cash rate by 25bp in March to 7.25% with a very high degree of certainty. A further move of 25bp to 7.5% in Q2 also seems likely. There is some possibility that the impact of earlier cash rate tightening becomes evident near-term and/or that the significant slowing underway in industrialised economies starts to impact emerging markets growth and commodity prices, such that this second rate hike may be avoided.

However, there is also a risk that Fed rate cuts and fiscal stimulus in the US have the world on firmer footing than we expect in 2H08, raising the risk of the cash rate rising beyond 7.5%.

With the RBA wanting to reverse the inflation path “reasonably quickly”, the risk of a hard landing for the economy in 2009 has risen noticeably, and we pencil in rate cuts for 2009 (25bp in Q1 and Q2).

Unlike most, UBS forecast two rate rises this year: one in March and one perhaps in the second quarter with the cash rate rising to 7.5%. That in turn will push home loan rates closer to 10%, which will suit the big banks.

The RBA pointed out that non-bank lending for housing had fallen by around 40% in the closing months of 2007 and the business had mostly been picked up by the existing banks: so the cartel is back in control.

What commentators are saying is that there will be a danger to business and employment in a number of key industries.

Retailing will be one, but not in food, rather the upmarket retailers like David Jones, which yesterday revealed a sharp rise in first half earnings (up 23% to around $87 million) and sales up 9.5% for the December half. Today JB Hi-Fi, a fast growing consumer electronic retailer, reported a 50% rise in sales and a 60% rise in first half earnings.

If the RBA is to have any credibility, it has to lift interest rates to force companies like those to experience some pain by way of slower sales and profits. Media companies will have to see advertising slowing or falling (especially TV companies). Online advertising will have to slow and online jobs ads will also have to feel the cold winds.

Employment is forecast by the RBA to rise by just under 1.5% over the next year: it was around 2.4% in 2007. That implies a gradual rise in the rate of unemployment and the number of jobless. Think of an unemployment number well above 5% (compared to 4.3% now) to make the RBA happy.

The bank believes households are well placed to weather the tighter conditions. Household savings rose to around 3% of net disposable income in the September quarter, house prices rose 12% on average last year, meaning prices rose faster than servicing costs and the sharemarket was up, although much of those gains have vanished in this year’s sell off.

The RBA says only a small proportion of households are feeling stress. Mortgage insurance payout figures from APRA show a sharp rise last year but are still low. And there have been no claims from Tasmania or the Northern Territory for two years.

Peter Fray

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Peter Fray
Editor-in-chief of Crikey