WEEKEND ECONOMIST: Behind the curve

The RBA has failed to get ahead of inflationary pressures and seems determined to illustrate the dictum that a central bank unwilling to risk a small recession is destined to inflict a much larger one.

The March quarter headline GDP growth outcome of 0.6 per cent over the quarter and 3.6 per cent over the year surprised financial markets, although not, we are pleased to say, readers of this column. The headline growth ‘surprise’ highlights the dangers of demand-side and sentiment-based approaches to forecasting economic activity, which misled some forecasters into expecting a contraction in GDP over the quarter. The outcome for the expenditure-based measure of GDP was close to the median market forecast, but the conceptually equivalent production and income approaches yielded much stronger estimates. The headline GDP figure represents the average of the three approaches and is our best estimate of GDP growth.

The market was also partly suckered by the RBA’s wishful thinking in its May Statement on Monetary Policy, with both headline and non-farm GDP growth coming in well above the RBA’s forecasts. Non-farm GDP growth
would need to slow by nearly 1.9 percentage points between now and Christmas to be consistent with the RBA’s forecasts.

While March quarter economic growth did moderate relative to the previous quarter, this was also from a stronger starting point given the upward revision to growth in the December quarter. Domestic final demand rose by 0.9 per cent over the quarter and 4.8 per cent over the year. This was down on the revised 1.4 per cent domestic final demand growth seen in the December quarter, but still well above growth rates that would be consistent with a moderation in inflation. Real net national disposable income, which better captures the welfare gains from a rising terms of trade, rose 1.1 per cent over the quarter and 4.2 per cent over the year. The terms of trade rose to a new record high on a national accounts basis in the March quarter, even before the increases in bulk commodity contract prices expected to flow through from the June quarter.

Current price GDP rose 1.5 per cent over the quarter and 7.3 per cent over the year, which suggests the nominal official cash rate is only neutral at 7.25 per cent, while the 10-year bond yield is still expensive at 6.62 per cent, despite now being well above the New Zealand 10-year bond yield. The household consumption deflator, which is conceptually closest to the CPI, rose 1 per cent quarter-on-quarter and 3.4 per cent over the year, the strongest annual growth seen since the price level jump associated with the introduction of the GST in 2000.

The May TD-MI inflation gauge rose 0.3 per cent over the month, taking it to a new record annual growth rate of 4.5 per cent. Rents, fuel and financial services made the main positive contributions. Core inflation (ex-volatile items) rose 0.3 per cent month-on-month and 4.3 per cent year-on-year from 3.9 per cent year-on-year previously. The trimmed mean, which proxies for the RBA's preferred measure of underlying inflation, rose 0.5 per cent month-on-month, although the annual rate moderated to 3.8 per cent from 4.3 per cent, with a larger increase in May 2007 dropping out of the calculation.

The inflation gauge points to a headline CPI outcome of 1.3 per cent over the June quarter and 4.3 per cent over the year, which is consistent with the forecast in the RBA's May Statement on Monetary Policy. However, with the trimmed mean entrenched at a monthly rate of around 0.5-0.6 per cent compared to an average rate 0.4 per cent in the March quarter, underlying inflation will likely come in worse than the RBA was forecasting in May.

This will likely elicit a tightening response from the RBA’s August Board meeting, but only serves to highlight the RBA’s persistent failure to get ahead of rising inflation pressures. The RBA seems determined to illustrate Allan Meltzer’s dictum, that a central bank unwilling to risk a small recession is destined to inflict a much larger one.

Given what we now know about growth in the December and the March quarters, we expect employment growth to average just under 30,000 per month over the June quarter, with a 27,000 gain forecast for May, while the unemployment rate is forecast to tick down to 4.1 per cent for the month. The tax cuts commencing from July 1 will be crucial in ensuring that the continued strong demand for labour is met through increased labour force participation. However, with the unemployment rate near generational lows and inflation expectations rising, there will be continued upward pressure on wages. Also on the docket next week is April housing finance, expected to post a 0.5 per cent decline for the month, extending the previous month’s sharp decline.

The RBNZ left the official cash rate steady at 8.25 per cent following its June Monetary Policy Statement, but adopted an explicit easing bias. Governor Bollard said that "the outlook for economic activity is now weaker than in our previous Statement. We project little GDP growth over 2008, and only a modest recovery thereafter, largely reflecting a weaker household sector. Government spending and personal tax cuts will provide some offset to this lower growth but will also add to medium-term inflation pressure. Consistent with the Policy Targets Agreement, the Bank’s focus will remain on medium-term inflation. Provided the economy evolves in line with our projection, we are now likely to be in a position to lower the OCR later this year, which is sooner than previously envisaged."

The MPS said that annual CPI inflation is now projected to peak at 4.7 per cent in Q3, reflecting the impact of higher oil prices. However, excluding the first-round effects of the emissions trading scheme, annual CPI inflation is projected to reach 2.3 per cent by late 2010. The RBNZ is projecting little GDP growth over 2008 and only a gradual recovery thereafter. March quarter GDP is forecast by the RBNZ to show an outright contraction of 0.3 per cent for the quarter.

The MPS noted that "we will be increasingly likely to carry out the interest rate reductions outlined in our projections." However, the RBNZ also noted that "interest rates are likely to remain well above neutral for some time until we are more confident that medium-term inflation pressures are easing."

Dr Stephen Kirchner is an independent financial market economist. His blog can be found at http://www.institutional-economics.com