We were surprised to see that the Reserve Bank lowered its growth forecast for both 2014 and 2015 from 2.75 per cent and 3.25 per cent respectively to 2.5 per cent and 3 per cent. The bank qualifies that downgrade by noting that "the differences are well within usual ranges of uncertainty for the forecasts".
A closer look at the indicated profile suggests the following:
1. Growth in the final three quarters of 2014 is now forecast to average 0.5 per cent per quarter. Under the old growth profile it seemed more likely that the bank was expecting a solid lift in momentum in the final quarter of 2014 in the order of 0.75 per cent compared to the implied 0.5 per cent in the new forecast.
2. The growth rate for 2015 has been lowered from 3.25 per cent to 3 per cent. It appears that the profile in the first half of 2015 at around 0.75 per cent per quarter has been retained from the May statement. However, an implied lift in momentum in the second half of 2015 to an average of around 0.85 per cent has been lowered to 0.75 per cent (the same growth pace as the first half).
3. As expected, the growth range forecast for 2016 is kept at 2.75-4.25 per cent. That implies a lift in the quarterly pace from 0.75 per cent to 0.9 per cent.
Two observations provide more background to the shift:
1. "Relative to three months ago when near term prospects for non-mining activity appeared to be improving the recent softness in some indicators has increased the uncertainty around the strength and timing of the pick-up in consumption and non-mining investment"; and
2. On the labour market, the May Statement on Monetary Policy indicated that the unemployment rate was likely to begin declining consistently from mid 2015. In this report that is not expected to occur until 2016.
The changed growth forecast includes several 'tweaks' with a softer-near term outlook for consumption and non residential building, a further expansion in dwelling investment later in the forecast period, and some shifts in the profile of resource exports. Interestingly, the Overview asserts that "the outlook for domestic growth is not materially different from that presented in the May Statement".
That may be understating things – certainly the change vis a vis the bank's February Statement on Monetary Policy (when GDP growth was forecast to run at a clearly above trend 3.5 per cent) is looking more material.
The bank has also changed its forecast for inflation although importantly, this looks to be solely due to the repeal of the carbon tax rather than the changed growth view. The bank expects the removal of the tax to reduce headline inflation by 0.75 ppts over the year to June 2015. About half of that will be the direct impact on electricity and gas prices that is unlikely to figure in underlying inflation. The other half reflects indirect effects on prices of other goods and services.
Accordingly the bank has reduced its forecast for underlying inflation from 2.5 per cent in the year to December 2014 to 2.25 per cent and from 2.75 per cent to 2.25 per cent for the year to June 2015. It has raised its forecast for the year to December 2015, reflecting the fact that the previous legislation had entailed a move to a floating price for carbon in mid 2015. The bottom line is that there does not appear to be any change in the underlying inflation forecasts that are being driven by the lower growth outlook.
The important observations around these forecasts are the following:
1. The bank expects the current soft patch for growth that is apparent in the June quarter to extend through the rest of 2014.
2. Whereas in May it expected growth momentum through 2015 to lift in the second half relative to the first half it now expects that momentum to remain steady.
3. In lowering the growth forecast for 2015 from 3.25 per cent (at or above trend) to 3 per cent (at or below trend) it provides some flexibility to cut rates over the second half of 2014. That is because any central bank that is predicting below trend growth in the year in which a policy change can be expected to have an effect allows itself the flexibility to cut rates if it deems necessary.
The key to that decision appears to be in the following comment: "there is some evidence that momentum in consumption growth has waned somewhat although at this stage it is unclear whether this reflects temporary sentiment effects or a more lasting reassessment of economic conditions by households".
It is our view that if the bank concluded the latter, and given its revised forecasts, it may decide to cut rates. However, we expect that it is being overly conservative. To believe that the final three quarters of 2014 will average growth of 2 per cent (annualised) seems to be assuming an overly pessimistic outlook for the consumer. We believe that through 2014 consumer spending will gather momentum at a faster pace than is currently implied by the bank.
When it recognises that trend it is likely to upgrade its forecasts for 2014 and restore its above trend forecast for 2015. That will preclude any perceived need for lower rates. Signals around consumer sentiment, retail sales, housing finance, house prices and dwelling construction activity all point to a more upbeat assessment of the economy than contained in the bank's forecast.
While the above analysis provides a scenario that might lead to a policy shift down the track, there is no evidence in the broader discussion in the August Statement on Monetary Policy to suggest any shift is on imminent. The key sentence that "on present indications, the most prudent course is likely to be a period of stability in interest rates" is retained unchanged from the Governor's decision statement earlier this month. There is no indication in the rest of the wording that the RBA has moved any closer to an easing bias.
Despite the unmistakable nervousness contained in this report we remain comfortable with our view that rates will remain on hold through 2014 and well into 2015 prior to the first hike in August.