Official cash rate could rise sooner than expected

THE acceleration of the mining boom and labour market pressure could push rates higher by May.

Stevens

THE acceleration of the mining boom and further pressure on the labour market on the back of the massive rebuild needed in flood-ravaged Queensland could put pressure on the Reserve Bank to raise the official cash rate sooner than expected.

Citi chief economist Paul Brennan said the Reserve Bank's forecast in its quarterly review, released last week, that the unemployment rate would fall only "very incrementally" and that inflation would pick up only gradually, implied that official interest rates would not need to rise significantly over the next 12 months.

The RBA forecast that while the Queensland flood damage would slow economic growth to 2.75 per cent this year, it expected the combination of rebuilding and the mining boom to lift growth to 4.25 per cent next financial year and 4 per cent the year after. The bank also said that employment would continue to grow rapidly and unemployment would fall from 5 per cent to 4.5 per cent by 2013, The Australian reports.

But Mr Brennan said there were risks that the RBA's forecasts of above-trend economic growth would lead to a faster tightening in the labour market and more inflation pressure than its official forecasts would suggest. "We continue to expect more tightening than currently priced by markets will be required to ensure that the large change in relative prices driven by the commodity boom doesn't spill over into a deterioration in inflation expectations," he said.

"We also suspect the RBA is underestimating the inflation pressure created by the flood rebuild against this backdrop of a mining and energy investment boom." The RBA last week held the official cash rate at 4.75 per cent and foreshadowed interest rates would remain on hold for the next few months, with inflation under control.

The expected $8 billion rebuild of Queensland after the devastating January floods, which was added to last week with the damage caused by Cyclone Yasi, had financial markets expecting rates to remain steady for most of the year.

But last week's update by the bank has fuelled expectations of a rate rise as early as May.

"With the next leg of the resources boom bearing down quickly, the RBA will have its hands full to keep the change in relative prices from seeping into a broader based deterioration in inflation expectations," Mr Brennan said.

He added that he expected 100 basis points of tightening this year, backloaded into the second half. The bank warned in its update last week the economy could be facing a re-run of the conditions that preceded the GFC.