Interest rate rise looms as wild card in election battle

AUSTRALIA'S market economists believe the Reserve Bank could have to raise interest rates next month in the middle of the election campaign, with new inflation figures likely to exceed its forecasts.

On Tuesday, the Reserve forecast that next week's inflation figures will show that underlying inflation fell below 3 per cent in the year to June, falling within its target range for the first time in three years.

But the minutes of the Reserve's July board meeting hinted that if underlying inflation tops 3 per cent, the August meeting would have to consider whether the new figures "materially changed the medium-term outlook for inflation" — and if so, raise rates.

Yesterday, a Reuters survey of 20 financial houses found most think underlying inflation will top 3 per cent on both the measures by which the Reserve has traditionally defined it.

Westpac, Goldman Sachs and UBS are forecasting an average reading of 3.1 per cent, slightly up from the previous quarter. Unless financial markets are in turmoil, that would probably force the Reserve's hand.

But traders from the same financial houses clearly disagree with their economists. The ASX target rate tracker puts the chance of an August rate rise at only 27 per cent. Traders expect the next rate rise is a year away.

The Reserve will also be influenced by global financial markets' reaction to the long-awaited results of stress tests on Europe's main banks, which were released last night.

If the reports fail to satisfy concerns about the banks or the stress test process, analysts warn they have the potential to send a new wave of fear through the global financial system, slowing lending and driving up wholesale interest rates.

The Bureau of Statistics yesterday estimated that soaring coal and iron prices pushed the average price Australia receives for its exports up 16 per cent in the June quarter, the sharpest rise since figures began in 1974.

But import prices rose only 1.9 per cent, with more than a third coming from higher petrol prices. That will have little impact on underlying inflation, or the risk of a rate rise.

On a rough measure, that implies Australia's terms of trade — the amount we get paid for our exports, relative to what we pay for imports — shot up 14 per cent in a single quarter, to be near record levels.

With China putting the brakes on its economy, however, coal and iron ore prices are forecast to fall.