SCOREBOARD: Rates hiatus

With the RBA's long-term forecasts little changed since November, the best bet is a rate hold for the foreseeable future.

The RBA’s monetary policy statement reiterates that the bank stands ready to ease if there is a material slowing in domestic demand. Now at the moment, the bank’s forecast shows that this isn’t the central expectation. Check the table below.

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Overall, the Reserve Bank’s forecasts are little changed since November. Near-term GDP has been revised down so that to the June quarter, growth is expected at 3.5 per cent from 4 per cent previously. Having said that, growth expectations beyond the June quarter are literally unchanged.

It’s the same for inflation. Underlying inflation excluding the carbon price is expected at 2.25 per cent in the year to the June quarter, which is a modest downgrade from 2.5 per cent in November, yet the rest of the forecast horizon is little changed. The best guess then is that rates are on hold for the foreseeable future.

A frequent question I am asked, is that if the RBA reckons that underlying CPI will be within the band until the end of next year – that's two years – then why aren’t they easing again?

I think there are several answers to this. Firstly, the forecast for CPI to remain in the middle of the band assumes the cash rate is changed. That's lower rates, higher growth and higher inflation.

Then, and as I noted after the CPI release, non-tradeable inflation isn’t within the band. It’s running at an annual rate of 3.75 per cent, which is leaving the exchange rate to do much of the work in dampening tradeable inflation and inflation overall. Well, that and the drop in some commodity prices which have been very volatile. If manufacturers are right in thinking that further policy easing would help ease their pain on the exchange rate front (and I’m not convinced they are), then the lower exchange rate would mean higher inflation. It would take away a key restraining factor. The fact that it’s really only tradeable inflation that has been coming down tells us that interest rates would then have to be higher to offset this lower exchange rate – you can see the circularity there. Higher interest rates would in turn lead to a higher exchange rate. The fact that non-tradeable inflation is high constrains the RBA somewhat.

Secondly, the risks aren’t one-way. Core CPI at 2.5 per cent certainly beats core CPI at 3.5 per cent. But it’s only in the mid-range and, as I have pointed out previously, it wouldn’t take much for us to be back at the top of the band. Indeed, the Reserve Bank notes that risks to inflation are evenly balanced. "The major downside risk comes from the highlighting of problems in Europe... the risks to the upside relate more to domestic factors,” it says. The fact is that non-tradeable inflation is high.

The RBA highlights that for the medium-term inflation outlook to remain benign, these non-tradeable pressures need to come in (productivity). If they don’t need to come in, then it is unlikely that inflation will be in the middle of the band.

I would add that there are decent upside risks to growth as well, both domestically and globally. Global policy overall is highly stimulatory (just stimulatory for Australia) and this isn’t going to change anytime soon. Confidence has pretty been much the only restraining factor for growth over the last year and that is improving. At this point I would highlight recent better-than-expected data out of the US.

That’s why the RBA is highlighting a material slowing in the demand, I think. Because in reality, it’s only a material slowing in demand that is likely to lead to lower non-tradeable inflation in the shorter term (and higher productivity in the medium-term), thus allowing them to ease rates again.

Adam Carr is senior economist at ICAP Australia. See Business Spectator's glossary for definitions of technical terms used in SCOREBOARD articles.