By Greg Peel

The stock and money markets, notes GSJB Were, have recently diverged in their expectations for Australian monetary policy. For the past two months the stock market has factored in elements of doom and gloom, centred around the European debt crisis, a forced slowing of the Chinese economy and an apparent stumbling of the US economic recovery. The bill and bond traders, however, have been fixated on Australia's resilient inflation rate.

The last RBA rise to 4.5%, made in May, was a surprise to many in the stock market coming, as it did, at a time when Europe looked like it might be set to implode. But the RBA downplayed Europe at the time and drew attention to Australia's soaring trade balance – a result of big iron ore and coal price jumps – and a CPI inflation rate that was not falling as low as the central bank had expected.

By June some observers were already suggesting the RBA would be forced to cut its cash rate given the gloomier global economic environment. The stock market tanked to back up such a call. But the trade balance is still growing and the RBA has now called the bottom of the inflation cycle post-GFC. Glenn Stevens, in his July statement, suggested Europe was under control and that emerging markets are driving the global economy. He kept the rate on hold, but declared the next move to be dependent on interim data releases.

The most important of these will be the June quarter CPI, due out on July 28 ahead of the August monetary policy meeting. Having crunched some numbers, the Westpac economists believe a rise in the CPI of less than 0.8% would be enough to keep the RBA on hold. But they are now forecasting a 0.9% rise, meaning a 25 basis point rate hike in August if their theory is correct.

We are yet to see any new quarterly settlements for bulk mineral prices, and here there appears to be disagreement in the market as well. One side points to falling spot prices in suggesting contract prices must also fall. The other side points to relentless Chinese economic growth, despite countermeasures from Beijing, which would suggest not. Last weekend's data release showing a 40% monthly jump in Chinese exports, and a 140% jump in trade surplus year on year, would tend to support the latter argument.

Assuming no substantial change to bulk prices before the August meeting, inflation will still be the key factor. And the surprising jump in employment registered in June will hardly help to calm the RBA on that front. Today we saw the release of May housing finance data, and they were also a surprise.

Economist consensus had housing finance by number of commitments rising 1.0% in May. Westpac was actually suggesting a fall of 1.0%. But the number came out at 1.9%. The value of new finance rose by 0.7%.

The reason Westpac was expecting a fall was a combination of reduced government stimulus, higher interest rates, and a growing unease about Europe and the global economy. But the most surprising part of today's May number, as ANZ points out, was a 0.2% rise in first home buyer financing following the 0.1% rise in April. Demand from first home buyers appears to have troughed already despite government hand-outs being much reduced. And fixed rate mortgages were most popular in May, suggesting consumers are bracing for higher interest rates ahead.

The numbers only reinforce Westpac's call for an August rate rise.

The Westpac economists note a 0.9% rise in the Q2 CPI, as is their prediction, would translate into an annualised trim mean of 3.0% - the top of the RBA's target zone. Previously, the RBA suggested inflation has likely troughed and would now track “in the upper half of the target zone over the next year”. But if Westpac is right, we're already there.

Westpac also notes the RBA is forecasting 3.25% GDP growth in 2010, 3.75% in 2011 and 4.0% in 2012. Westpac is only forecasting 3.2% growth for 2011 and 2012 by comparison. On the RBA forecasts, and an inflation rate of 3%, the central bank would have little choice but to raise, the economists suggest. Alternatively the RBA could lower its GDP forecasts, but the next round of forecasts is not due until after the August meeting.

GSJB Were notes the money market is currently pricing in 2.9% inflation. The Weres economists nevertheless have a forecast of 3.3% for 2010 rising to 3.5% in 2011, which is up from their earlier 3.3% forecast. The increase is due to the lagged effect of the recent tumble in the Aussie dollar, which translates into higher AUD value for commodity exports.

On that basis, one might expect Weres to echo Westpac in assuming another rate rise around the corner. This is not the case however, and for two reasons Weres expects the RBA to remain on hold until at least November.

The first reason is that it expects the RBA to continue to “stare down” rising inflation until there is more clarity on Europe and the global economy. The second reason is that Weres is expecting Australian banks to lift their mortgage rates in the interim, regardless of the RBA's stance, given rising funding costs.

So we have disagreement among economists, as usual. Either way, pencil in July 28's CPI release as the key factor.

For more on expected independent mortgage rate rises, see today's Bank Upgrade And Broker Conviction.

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