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The RBA raised the cash rate by 25bpts to 3½% yesterday.

· The improving economic backdrop and the risk that inflation may begin to lift again are the main reasons why the RBA is lifting interest rates, and will continue to do so.

· But today’s Statement has muddied the waters a little on timing of future moves.

· One implication is that another 25bpt move in December is no longer a certainty.  It will depend on the data flow and market conditions over the next month.

· We expect the cash rate to be in the “low 4’s” by QI 2010.

The RBA has pushed further down the normalisation path by lifting the cash rate by 25bpts to 3½%.  The move was widely expected and fully priced.

The run of economic data has indicated for a while now that official forecasts were too pessimistic.  The Government revised its views in the Mid-Year Economic & Fiscal Outlook (MYEFO) yesterday.  The RBA will put its new figuring on the table in the Statement on Monetary Policy on Friday.  The shape of those new RBA forecasts is already broadly known.  They involve a return to trend GDP growth during 2010, an inflation trough lower than previously thought and a risk that inflation rates will be lifting again in 2011.  There are enough hints in today’s RBA Statement to suggest that the Bank is a little more bullish on growth and expects a slightly higher inflation outcome than Treasury.

Either way, the economic cycle is turning at a point where there will be less spare capacity in product and labour markets than previously thought.  There is also something of the flavour of disappointment in recent RBA commentary.  The inflation slowdown to date is relatively modest compared with previous cycles.  And relatively modest given five quarters of sub trend economic growth and four quarters of rising unemployment.  Part of the disappointment lies with the structural inflation issues that are pushing against the cyclical forces.  The monetary authorities can do little about these structural forces.  But they would clearly be concerned about an environment where structural and cyclical price drivers were pushing in the same (upwards) direction.

The improving economic backdrop and the risk that inflation may begin to lift again are the main reasons why the RBA is lifting interest rates.  That much is clear from a big picture perspective.   But today’s Statement has muddied the waters a little on timing of future moves.

RBA commentary at the time of the first rate rise in October indicated that  the withdrawal of policy stimulus should be “gradual”.  Governor Stevens in a speech later in October noted the task for policy makers is “to react in a measured but prompt fashion to changes in the risks”.  The RBA Board minutes a few days later suggested it would be “imprudent” to keep low rates in place when they were no longer needed.  This progression suggested that the pace of rate rises was being stepped up.  But today’s Statement has taken us back to the start – the aim is again “to lessen gradually the degree of monetary stimulus…”.

One implication is that another 25bpt move in December is no longer a certainty.  It will depend on the data flow and market conditions over the next month.

Nevertheless, we still think that the RBA will continue to take out the “emergency component” of current interest rates and get rates up to 4% or a touch higher.  We still think that they will be there by QI 2010.  That level marked the low point for previous rate cut cycles.  So policy would still be at expansionary levels.  Once a self-sustaining recovery is confirmed, a traditional tightening cycle could get underway.  We expect to see a “normal” or “neutral” cash rate of 5% by end 2010.

Inflation risks are tilting to the upside again.  But inflation looks more of an issue for 2011 rather than the near term.  The fundamental price drivers favour further disinflation in the near term:

· Upstream price pressures are dissipating – core producer prices fell at an annualised rate of 2.2% over the six months to September.

· Labour cost growth is slowing – unit labour costs fell at an annualised rate of 7.3% in HI 2009 and business surveys suggest a flat picture over the next year.

· Import prices are falling – imported consumer goods prices fell at an annualised rate of 19% over the six months to September.

· The global output gap is widening and the Aussie dollar is rising – tradables inflation should remain well contained.

· Inflation expectations are towards the low end of the range of recent years.

Our forecasts have the underlying CPI running at 2¼% in HII 2010 before lifting to 2¾% by mid 2011.

all data is sourced from Australian Bureau of Statistics material (www.abs.gov.au)