WEEKEND ECONOMIST: An inflation invitation

In lowering its inflation forecasts and predicting extended weakness in the labour market, the Reserve Bank is hinting at more than one rate cut to come.

When assessing the Reserve Bank's Statement on Monetary Policy we are interested in four key areas. Firstly, the choice of words in the final paragraph of the introduction. Secondly, the forecasts for growth and inflation. Thirdly the key themes, particularly around risks. And finally, evidence around the banks' own liaison work since there is no formal vehicle for publishing these results.

On the choice of words, we are a little disappointed. In the governor's statement on Tuesday he used the term "at today's meeting the board decided to use some of that scope". Of course "scope" was referring to the fact that the inflation outlook allowed scope to ease further to support demand.

This term gave us some encouragement that the prospect of a near term follow-up move was significant. Unfortunately in today's statement that term was no longer in use and the wording around the Board's decision was more in line with a neutral bias rather than an easing bias. We may be reading too much into this change but nevertheless given our view that rates are likely to be cut further in the near term, excluding this term is disappointing.

We will look for the minutes of the board meeting which are released on May 21 for further clarification of this point.

The changes to the forecasts were predictable. The most significant was a reduction in the forecast for underlying inflation for the year to December 2013 from 2-3 per cent to 2.25 per cent. With the March quarter print for core inflation being only 0.4 per cent maintaining the 2-3 per cent range would have implied the expectation that the last three quarters would average around 0.7 per cent, a marked lift from the March quarter number. We agree with that forecast change. In fact our annual forecast is even lower at 2 per cent. The outlook for 2014 is unchanged at 2-3 per cent.There has also been a marked reduction in the forecast for headline inflation, from 2-3 per cent for 2013 to 2 per cent.

Growth forecasts are largely unchanged with the key theme that growth is expected to be a below-trend 2.5 per cent in 2013 returning to trend 2.5-3.5 per cent in 2014. A slightly more optimistic tone figures in the forecast to June 2015 being revised up from 2.5-3.5 per cent to 2.5-4 per cent. A minor note of interest is that whereas we expect the Treasurer's Budget forecast for GDP growth in both 2012-13 and 2013-14 to be 2.75 per cent the Reserve Bank opts for 3 per cent in 2012-13 and 2-3 per cent in 2013-14.

The bank's theme for the economic outlook is a gradual rebalancing of economic growth from mining to household spending, non-mining investment and exports. However, they recognise that while this rebalancing appears to be beginning there remains considerable uncertainty about exactly how it will unfold. The second theme is around a degree of pessimism with respect to the labour market. It is now expected that the unemployment rate will continue to rise until the middle of 2014 at which point a return to trend output growth will improve conditions. That implies that below trend growth can be expected in the first half of 2014 as well as 2013. The key risks around the rebalancing hypothesis come from the labour market itself. If the weakness in the labour market is pronounced then the recovery in household spending and the housing market will be more modest. In fact the key risk for the low interest rate policy – that is, a sharp increase in house prices and household leverage – is significantly mitigated if the labour market remains weak. We expect that the bank's subdued outlook for the labour contains any concerns around overstimulating the labour market.

This view around the labour market is also critical to the inflation outlook. A softening labour market will continue to give encouragement that wage pressures will remain contained. It is our reading of this statement that the bank expects weak wage pressures and other downward pressure on inflation due to firms seeking efficiency gains. An environment of waning pricing power seems to be the explanation behind recent surprisingly soft inflation prints in the tradables sector. They are not reflecting the Australian dollar, which has remained steady for the last few years, but more downward pressure on domestic margins described by the bank as "disinflationary pressures on the price of tradable items".

This rebalancing of the economy will be critically dependent on the attitude of business. The bank recognises that the near term outlook for investment is subdued, confirmed by weak business credit and soft business confidence. Much reliance is placed in the statement on the ABS capital expenditure survey. It is pointed out that this survey indicated positive investment plans in the non-mining sector for 2013-14. We have discussed that survey, highlighting its volatility and inconsistency with the confidence and credit data. It appears that the next survey, which prints on May 30, will be very important in the bank's deliberations on how this rebalancing process is proceeding.

Of course the link between housing and household expenditure and the business sector is employment. If the employment picture continues to deteriorate in the eyes of the bank then their confidence around the contribution to the rebalancing from the household sector will also wane.

This key dynamic will certainly be a critical factor in determining whether our own view, that the bank will need to provide further stimulus, is correct.

There is some rich information in the statement around the banks' liaison work. They have been given some encouragement in the housing outlook with building firms noting that enquiries from prospective purchasers and visits to display homes have increased. With house prices rising and a tight rental market it is not surprising that there is some movement in that regard.

On the other hand, liaison with firms in general indicates that they remain cautious about undertaking significant expansion. They are also cautious about hiring staff. As discussed above, if caution with respect to investment and employment is sustained then the pace of rebalancing of the economy will remain tepid. The bank's own forecasts for a rise in the unemployment rate with a peak in mid 2014 suggests that they accept the reliability of these liaison results.

The commentary around the international economy appears to be a little less buoyant than in previous statements. Previously there appeared to be considerable confidence that the US economy was likely to provide an upside surprise. In this statement emphasis seems to be placed more around downside risks for the US being highlighted by fiscal policy potentially breaking the building momentum of the US recovery although expansionary monetary policy and balance sheet repair is recognised. Chinese risks also appear to be more concerning highlighted by the fast pace of credit growth, excessive house price appreciation, and overall challenges for macro-economic management. Appropriately, risks around Europe are still to the downside around banking and fiscal problems in economies which are already fragile.

This statement depicts a central bank which has become more confident around the inflation outlook but recognises that this confidence is justified by a weakening labour market and moderate wage pressures along with deflationary pressures in the domestic goods and services markets. Its forecast for inflation indicates that there is further scope for easing policy to assist the rebalancing of the economy away from mining towards domestic demand. There is not a high degree of confidence in this statement that the process can be expected to develop satisfactorily and its own liaison highlights the reluctance of business to participate. We expect that this situation will persist for the remainder of this year and into next year. Such an environment is very likely to lead to the bank using its scope to ease policy significantly.

Bill Evans is Westpac's chief economist.

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