For a more comprehensive round up of the week, listen to Stephen’s full report here.
The one clear message from two doses of Reserve Bank (RBA) economic analysis released last week at the first policy meeting of 2014 and in much more detail in the quarterly Monetary Policy Statement is that the RBA wants a period of stability in interest rates until it becomes clearer whether the Australian economy is tracking somewhere in line with the its latest forecasts. In essence, those forecasts show both CPI inflation and underlying inflation pushing above the top of the RBA’s 2-3% target band in 2014 before moderating back inside target band in 2015 and 2016 and economic growth running below trend in 2014 before pushing above trend in 2015 and 2016.
These growth and inflation forecasts are quite unusual. Normally, economic growth accelerating above trend, as the RBA is forecasting for 2015 and 2016, would be associated with upward pressure on inflation. Instead, the RBA is forecasting decelerating inflation as growth picks up. The rationale is that the forecasts represent a reversal of the recent unexpected lift in inflation at a time of sub-trend economic growth in Q4 2013. The high-side inflation surprise has been primed perhaps by a range of one-time factors – government tax changes including the carbon tax, higher petrol prices (back in Q3 2013) and food prices (in Q4), and an earlier-than-expected pass-through of price pressures from the sharply weaker Australian dollar from mid-2013. The RBA draws comfort that wages growth has been moderating to a decade low with little sign of any pick-up in what is still a soft labour market.
If wages growth is low it is reasonable as far as the RBA is concerned to expect that once the temporary pressures on the inflation rate subside, the inflation rate should subside. However, the RBA also admits that there is a risk that it could be that inflation is picking up at lower levels of demand than has been the case in the past, a development very difficult to measure and monitor.
It is also possible that demand may rise faster than the RBA is forecasting currently even in an environment of low wages growth. Growth in household spending is not necessarily tied to growth in household income. Over the past 5 years Australian households have been saving more than 11% of their income as opposed to less than 5% on average in the decade before the global financial crisis. It is possible, indeed quite likely, that at some point the household savings ratio falls as rapidly as it rose in 2008 and in the process boosts household spending sharply.
Strong home buying activity and much better retail sales over recent months indicate that the household savings ratio may be starting to slip already. The RBA has factored some of this in to its growth forecasts, but it is also still allowing for sharply declining business investment spending driven by the fall off in mining investment spending. The RBA is also allowing that the second leg of the resource sector investment boom, stronger export volumes, is starting to come through too. All told it is complex outlook of stronger and weaker influences on demand for 2014 and 2015.
Quite reasonably the RBA wants to wait and see what will happen over the next few months before committing to what its next cash rate move might be. Normally when the RBA is forecasting a period of above target inflation and improving economic growth it would be starting to warn borrowers that current low interest rates may not persist. This time, the RBA is probably not inclined to provide this warning, partly because of the uncertainty surrounding the growth and inflation forecasts, but also because it does not want the market to build in expectations of future interest rate hikes that might reverse the so far welcome orderly depreciation of the Australian dollar.
One increasing risk in the wake of the RBA’s comments and analysis last week is that the RBA’s reluctance to provide warning of potentially higher interest rates means the next rate-hiking cycle could start with little or even no warning. Local economic readings will need to be assessed carefully over the next few months, but if they continue, on balance, to throw upside surprises in terms of growth and inflation our current forecast of a first 25bp rate hike by the RBA in August is at risk of needing to be brought forward to May after the Q1 2014 CPI report in late April. What is more certain is that a prolonged run of weaker than expected local economic readings will be needed if the RBA is to consider cutting the cash rate further and this stage that looks by far the lowest probability event among possible interest rate changes this year.