The National Australia Bank believes the question of an interest rate increase is now all a matter of timing.
And the bank now also says there's a 40% chance of a further rise mid year if the economy and price inflation doesn't slow appreciably by then.
In commentary accompanying the first of its business confidence surveys for 2008 (see below) the bank's Chief Economist, Alan Oster, said the bank believed the Reserve Bank would lift rates in March after waiting and watching conditions next Tuesday at its first meeting of the year.
"As shown by both the latest CPI and the increased retail price and margin measures in the survey(see above graphs) there have been a significant deterioration in the short term core inflation outlook. In brief, excess demand has increasingly been reflected in accelerating retail prices.
"The rate of acceleration was much higher in retail: movements appear to reflect a sharp (and higher than expected) increase in margins.
"As a result, retail prices increased by a very fast 1.7% (on a 3 month seasonally adjusted basis) in December. As a result the Survey’s annual measure of retail prices jumped 0.3% to 2.7% – and significantly up from around 2% in mid year.
"While differences in coverage result in different levels, both the Survey’s measure and the RBA’s preferred CPI measures point to an acceleration in core inflationary pressures during the second half of 2007 – and with no signs of an easing up in that momentum in the latter parts of 2007.
"We now see core inflation peaking at around 3.75% in mid 2008 (up a 0.25% on previous forecasts) and not moving back into the RBA’s preferred 2%-3% target range until early next year.
"Clearly on these forecasts the RBA will feel the need for further insurance – and unless the world outlook deteriorates much further and faster than we (and the RBA) expect it is just a question "of when not if".
"Given the turbulence in world financial and equity markets, the RBA will probably wait out its next meeting providing markets time to settle before hiking again.
"Aggressive rate cuts in the US and deteriorating growth prospects in Europe, however, do not represent a reason for the RBA staying its hand in current circumstances.
"Only if the RBA significantly lowers its global growth outlook (relative to what it and we currently see as the most likely outcome) would it consider a more lengthy pause.
"On the basis that global markets will take some time to settle back to better reflect economic fundamentals we see the more likely timing of the next rate rise as March – rather than the February meeting.
That said, if markets settle more quickly than expected, a February rate rise could not be ruled out.
"Also it bears noting that if the domestic economy does not slow as quickly as expected a second (mid year) rate rise is also a possibility (40 percent probability). Moves to further tighten fiscal clearly would help alleviate these pressures.
"Given the deterioration in the domestic inflation outlook and the still strong local demand we have delayed the timing of the RBA easing phase till early 2009 – but we would still see the easing cycle when it comes to lower current rates by around 100 basis points.
"In our view, that would be consistent with bringing monetary policy settings back to a more neutral (but still a firm) policy stance by late 2009."
Mr Oster said that it was clear from the Nab survey for December (and other partial data such as strong retail sales and falling unemployment) that the Australian economy finished 2007 on a strong note.
"As noted earlier, with the results of the survey implying domestic demand increased by around the 4% (annualized rate) in the December quarter together with employment and capacity utilisation still at strong levels, GDP in 2007 looks to have increased by around 4% overall in 2007 – and domestic demand by around 5.5% during the year
"The survey does point to slower growth going forward but not to a sharp slowdown. Taking on board the wealth effects of lower equity markets together with the impact of the expected further tightening in both fiscal and monetary policy we have marginally lowered our activity forecasts for 2008. In summary we now expect:
• GDP to increase by 3.0% in 2008 (previously 3.2%);
• But we have not changed our forecasts for GDP in 2009 at 3.0%. That, however, masks a further slowing in non farm GDP to around 2.5% offset by a rebound in farm GDP of around 20%;
• For the financial year 2007/08 these forecasts are consistent with GDP growth of 3.5% and 3% in 2008/09.
"In many ways our forecasts still see the key issue for local policy makers as reducing excess demand pressures.
"Despite current uncertainties about the global outlook, with China still strong, we still expect very large price increases in upcoming iron ore (30%) and coal negotiations (40%). As a result Australia’s terms of trade are likely to move up further during mid 2008 before finally starting to ease back from late 2008.
"Reflecting tighter policy and associated lower growth in asset prices (house price increases are expected to slow to around 5% and little growth is expected in equity markets) our forecasts see the pace of domestic demand slowing from the current annual rate of 5.5% to nearer 3.5% during 2008 and around 3% during 2009.
"These forecasts imply that unemployment will remain
