Weekend Economist: Discourse discord

In its statement on monetary policy (SoMP) the Reserve Bank of Australia has lowered its near term forecasts for core inflation; raised its near term forecast for economic growth but lowered its growth forecasts for 2015.

As expected, the surprise 0.5 per cent print on core inflation for the March quarter in contrast with their expected print (our estimate) of 0.8 per cent has led to a reduction in the core inflation forecast to June 2014 from 3 per cent to 2¾ per cent and a reduction in the forecast to December 2014 from 2¾ per cent to 2½. per cent.

The growth forecast for the year to June 2014 was increased from 2¾ per cent to 3 per cent. That acknowledged the stronger than expected print for fourth quarter 2013 and the likely near 1 per cent print for first quarter 2014. However the bank did not raise the December 2014 growth forecast. The implied growth pace in second half 2014 in the February SoMP (around 0.6 per cent per quarter) has been retained. Given that the likely growth pace in the first half of 2014 will be around 0.8 per cent it is mildly surprising that the bank has decided to forecast a shift back in the slower growth pace in the second half.

Forecast growth for the year to December 2015 has been reduced from 3 per cent- 4 per cent to 2¾-3¾ per cent.

The explanation which the bank gives for lowering its 2015 forecast is entirely around the 4 per cent increase in the exchange rate since February.

By explicitly attributing the downward revision in growth to the exchange rate the bank is sending a very clear message about its sensitivity to the recent lift in the Australian dollar particularly at a time when commodity prices have fallen.

We now have the somewhat unusual situation where the narrative in the SoMP refers to trend growth not being exceeded until mid 2015 despite the forecast recognising that 3 per cent growth is likely to be achieved by June 2014.

While the bank recognises that the outlook for consumption and dwelling investment is slightly stronger that is not sufficient to offset the dampening impact of the higher Australian dollar. This comes as a mild surprise given that consumption momentum has clearly lifted and is easily capable of offsetting the impact of the higher Australian dollar.

There is no evidence of any attempt to "talk down the Australian dollar" in this statement. The closest we get is a statement that "with resource prices expected to decline further, historical relationships suggest that the exchange rate could move lower over time". From our perspective we would expect some downward pressure on the exchange rate as a lagged response to falls that have already occurred but we do not expect much further downside on commodity prices.

In his statement on Tuesday the governor indicated a more confident attitude towards the labour market. Consequently, arguably, the most interesting narrative in this statement is around labour market views. In that regard the revised assessment is quite conservative. The statement on Tuesday left open the possibility that the bank expected that the unemployment rate had peaked. However, this is clarified with the following: "forecasts now encompass less of an increase in the unemployment rate over the next year. However, the recovery in the labour market over the forecast period is expected to be fairly drawn out ... the unemployment rate is not forecast to begin declining consistently until after mid-2015 and even then the decline in the unemployment rate ... is expected to be relatively modest".

The discussion around the inflation rate also bears some consideration. The bank was apparently wrong-footed by the sharp lift in core inflation in fourth quarter 2013 and surprised by the sudden slowdown in first quarter 2014. This profile is attributed to statistical "noise". In summary, it advocates looking at the average of the two quarters and concludes that underlying inflation over the past two quarters has averaged a little under ¾ per cent - "somewhat higher than what was the case a year or two ago".

There is little evidence of any enthusiasm for a lift in non-mining investment. The bank notes that "firms continue to report through the bank's liaison program that they are waiting to see a sustained pick up in demand before committing to increasing capital expenditure".

Equally the recent promising lift in consumer spending is only described as "a moderate pace of growth". That is despite recognition that the surge in household wealth is likely to accommodate a fall in the savings rate.

It is interesting that the bank chooses to point out that house price inflation has "moderated a little in recent months and auction clearance rates have come down". Nevertheless it is not prepared to conclude whether this early signal represents a shift to a more sustainable growth rate for house prices. However the decision to make that observation indicates a preference for that view.

Globally the bank notes that growth of Australia's major trading partners looks to have moderated a little in the March quarter but remains confident that the growth pace will stick around average for the year. Indeed it notes that the moderation of growth is likely to be temporary.

This statement is surprisingly down-beat. Despite clear evidence of a lift in momentum, particularly in the household sector, and markedly improved employment trends the bank takes a clear conservative approach. The lift in household spending is described as modest; the unemployment rate is still expected to rise and no marked improvement is anticipated before the middle of 2015. Specifically due to the 4 per cent lift in the Australian dollar since February, the growth outlook for 2015 has been lowered from a clear "above trend pace" of 3½ per cent to a near trend pace of 3¼ per cent. That is despite the need to raise the near term forecast implying a clear downshift in growth momentum over the next 12 months.

The overview ends with the assessment that the "current accommodative monetary policy setting is likely to be appropriate for some time yet". That is a very logical interpretation of this report, emphasising that it is reasonable to conclude that the bank sees little chance that interest rates will need to be lifted in 2014.

This report suggests that the bank may well have a current approach to policy which is in line with our own views that rates are likely to be on hold for more than a year. Note that this view is supported by the bank's forecast for growth at or below trend. Of course the report does put considerable emphasis on the restraining effect of the Australian dollar. Our forecasts for commodity prices and the global economy indicate limited downside risks for the Australian dollar over the next few years.

Bill Evans is chief economist with Westpac.