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Australian annual economic growth pushed above long-term 3.1% trend growth in Q1 2014 and by quite a margin accelerating to 3.5% y-o-y from 2.7% y-o-y in Q4 2013. Above trend economic growth combined with signs of the unemployment rate starting to decline and annual CPI inflation at 2.9%, very close to the top of the RBA’s 2-3% target range, would normally mean only one thing for the RBA’s cash interest rate – it will soon be moving upwards, especially as it is currently lodged at a very accommodating, 60-year low of 2.50%. The RBA, however, is showing no signs that an interest rate increase is in the wind. Instead, the RBA continues to signal that a protracted period of interest rate stability lies ahead, but predicated on a view that the strength in various key economic readings in Q1 will not gather pace in Q2.

The RBA’s economic view is that the sharp lift in economic growth in Q1 and the quite sharp fall in the unemployment rate over recent months from 6.1% to 5.8% are both probably anomalies in a longer-term trend of moderately improving economic growth and a still lack-luster labour market. The RBA also holds the view that inflation is contained, mostly by weak wages growth, and will travel inside target band over the next year or two, even though high side surprises in two of the last three quarterly CPI reports had inflation almost at the top of the band in Q1 and threatening to go above 3% in Q2.

The RBA’s economic views are perfectly reasonable in our view. The unexpectedly big GDP increase in Q1, up 1.1% in the quarter, was driven by net exports contributing a whopping 1.4 percentage points (pp) to growth in the quarter. This big net export growth contribution reflected the start of stage 2 of the resources boom, much enhanced export volumes because of the earlier large lift in investment in resource projects in stage 1. The falling investment in resource projects has had much greater air play in official economic growth prognostications until recently. However, the stage 2 export boom is likely to be lumpy. April international trade data showing a return to trade deficit after a run of big surpluses January through March implying that it is highly unlikely that net exports will contribute much, if anything at all, to GDP growth in Q2.

Without the benefit of the one percentage point plus contribution from net exports that occurred in Q1, Q2 GDP growth looks quite soft, reliant entirely on what is happening to domestic demand in the economy. In Q1, final domestic demand grew, but only by 0.3%. Among the better component increases within domestic demand in Q1 were investment in dwellings, up 4.7% in the quarter and contributing 0.2pp to GDP growth, and household consumption expenditure, up 0.5% and contributing 0.3pp to growth. As expected, not all components were stronger in the quarter. Total government spending detracted 0.1pp from growth in the quarter and non-dwelling construction detracted 0.2pp. Clearly, the contributions to growth within domestic demand are mixed, but overall still quite soft and there is little reason to expect much better in Q2.

On this basis, Q2 GDP growth, without any contribution from net exports, looks like being no better than about 0.3% q-o-q and growth seems to see-saw from very strong in Q1 to very soft in Q2. Probably a better way is to look through quarter-to-quarter volatility in growth and look at the half year. Taking 1.1% Q1 GDP together with forecast 0.3% Q2 GDP means GDP would grow 1.4% in the first half of 2014, or 2.8% on an annualized basis, still tracking below long-term trend. Our best guess is that the RBA is making a similar GDP growth calculation and as a result sees the unemployment rate staying sticky around current levels with persistently soft wages growth containing inflation.

It is worth keeping in mind, however, that economic growth surprises appear to be starting to migrate to the upside in the world’s three biggest economies – the United States, China and Japan. It is possible that Australian GDP growth surprises again on the strong side of expectations in Q2, what we would consider a risk case forecast, albeit a low probability forecast at this point. If growth turns out to be stronger than expected in Australia there is not a lot of room for the RBA to stay comfortable with its stable interest rate outlook and it would quickly change its guidance to the market from interest rates on hold to the need for less accommodating monetary policy. Our core view is that the cash rate will remain on hold at 2.50% through to early 2015, but the risk case is more upside growth surprises leading the RBA to surprise the market with a change in guidance followed promptly by rate hikes starting as early as Q3 2014.