Weekend Economist: End of easing?

The surprise December-quarter inflation data should see the Reserve Bank drop its easing bias, putting a floor under the Australian dollar.

The December quarter inflation report surprised forecasters and markets.

The consensus view was for 0.5 per cent (core) and 0.6 per cent (headline) and the report printed 0.9 per cent core and 0.8 per cent headline.

In the event annual core inflation has lifted from 2.4 per cent to 2.6 per cent and annual headline inflation has lifted from 2.3 per cent to 2.7 per cent.

From the perspective of the Reserve Bank this means that whereas, in its November statement on monetary policy, it could comfortably forecast core inflation as 2.5 per cent to June 2014; 2–3 per cent to December 2014; and 2–3 per cent to December 2015, the forecasts for the February statement on monetary policy will need to be reassessed. The June 2014 forecast is likely to be lifted to 2.75 per cent, implying 0.6 per cent in both March and June quarters of 2014 with an outside risk of a 3 per cent forecast implying 0.75 per cent in both March and June quarters.

If it opts for the 2.75 per cent forecast then it can comfortably retain the 2–3 per cent forecast for 2014. If it opts for the 3 per cent forecast to June then it might choose a 2.5 per cent –3.0 per cent forecast for December 2014. Either way it will retain the 2–3 per cent forecast in 2015.

We favour the 2.75 per cent and 2–3 per cent option for 2014.

The decision will be determined by the Reserve Bank’s assessment of the sustainability of this surprise lift in inflation. It is our view that the lift is almost exclusively due to the impact of the 12 per cent fall in the Australian dollar over the June and September quarters.

The key contributors to this boost were overseas holidays; audio and visual goods (totally imported) and imported fuel. On the domestic front the only really threatening increase came in “house purchase” which printed 1 per cent compared to our estimate of 0.8 per cent.

On the other hand “clothing” printed a negative indicating weak demand with importers having to absorb margin compression.

Our research indicates that the collapse in domestic demand conditions over the course of 2013 (we forecast final demand slowed from 4.2 per cent growth in 2012 to 0.8 per cent in 2013 – with three of the four quarters already known these forecasts are unlikely to be too far from the mark) will impact deflationary pressure on the economy through 2014. We would also argue that the impact of the weaker Australian dollar will have its peak effect in the December quarter – weakness in domestic demand will contain the secondary impact on inflation from the weaker currency in subsequent quarters.

Further, this inflation development is likely to force the board to abandon its easing bias at the February board meeting, providing a comfortable floor for the Australian dollar around the 88-90 US cents. The inflationary pressure from the weakening currency is therefore likely to diminish markedly in the March quarter and beyond.

In general, inflation reads carry different significance depending on the stage of the policy cycle. During a tightening phase, when demand is not a concern, upside surprises on inflation tend to draw a more immediate policy response. During an easing phase though, when demand weakness is the dominant concern, the Reserve Bank will be more prepared to take a medium term view on inflation, ‘looking through’ near-term shifts. That is particularly true when those shifts leave inflation within the 2–3 per cent target range and are seen to be driven by temporary influences such as Australian dollar depreciation. Therefore it is extremely unlikely that the board would opt for higher rates in the near term, choosing to keep rates on hold till mid year.

If we are correct on this dynamic, and the inflation lift turns out to be transitory, policy is likely to resume being driven by the outlook for the real economy.

In that regard we see the following forces:

1. Domestic demand in 2014 will be shaped by a number of powerful and conflicting forces, differentiating this period from past cycles. No doubt residential construction is trending higher. However, at the same time the recent unprecedented upswing in mining investment is now turning down at a rapid pace and public demand remains constrained as government’s focus on strengthening their balance sheets at a time of mixed revenue growth.

We assess that the dampening impacts on spending from the downturn in mining investment and below trend public demand growth will outweigh the likely boost from an upswing in residential construction. We anticipate that mining investment in 2014 will be some $9 billion lower than in 2013, while the rise in public demand over this period will potentially be $7 billion below trend.

By contrast, the direct boost from a rise in housing construction during 2014 is likely to be closer to the $4 billion mark. We recognise that the housing market would more than compensate for this shortfall if there were to be a “normal” impact on consumer spending from the boost to wealth resulting from the increase in house prices. However, we expect, in this cycle, that households will be much more circumspect around spending any gains in asset prices.

2. The labour market will remain soft – jobs growth will be constrained, impacting incomes and confidence. The unemployment rate is likely to rise to 6.5 per cent by mid 2014.

The weakness of the labour market has already generated a significant slowing in wage inflation. Real non-farm unit labour costs are contracting, as rising productivity growth (driven in part by resource exports and more efficient business practices) outstrips weak labour compensation. The disinflationary forces emanating from the labour market are thus considerable and are expected to persist throughout 2014.

3. Business will resist employment and investment expansion. This will be largely because their sales and profit expectations remain anchored partly due to weak household demand; low confidence and, now, concerns about the impact of rising interest rates on a fragile business environment.

4. Speculation around fiscal policy will unnerve household confidence through the first half of 2014 culminating in a tight Commonwealth budget.

5. Momentum in the housing market will ease – we expect deteriorating affordability and lingering job uncertainty to start to constrain owner-occupier activity in 2014. Fears around rising interest rates that will result from the December quarter inflation print, could also be a factor, particularly for investor activity in the sector.

6. The world economy is sending mixed messages, but overall it will be a disinflationary influence in 2014. While we retain a world growth forecast for 2014 well below the official consensus (as proxied by the IMF), prospects in the developed economies have improved modestly, with US growth likely to exceed 2 per cent and Europe no longer contracting. Regarding our major trading partner though, the direction of change in Chinese domestic demand looks pretty clear, and that direction is down. The general tilt of Chinese policy is towards tightening and our reading of the investment pipeline implies very strongly that there will be a slowdown in the overall construction cycle (with some sectoral divergence). Other major emerging markets are suffering from capital outflows as the developed world outlook solidifies. The net effect on Australia’s terms of trade will be negative. We anticipate a fall of around 5 per cent through 2014. Note that, going back to the late 1980s, there have been four fiscal years in which both the terms of trade and real non-farm unit labour costs declined. In every one of these instances, official interest rates concluded the year lower than at the outset.

So what does this mean for interest rates over the course of 2014? The Reserve Bank is likely to require convincing evidence of our assessment of inflation risks before it opts for lower interest rates. That will certainly mean a need to assess the March andJune quarter inflation reports, which will print in late April and late July, because of this inflation “scare” a longer run of data to reveal whether our assessments in points 1 – 6 are correct. A further delay in the timing of the next rate cut from our current view of May until August is therefore likely. As we have argued before, the decision to lower rates further from the current record lows, given the long pause since the last move, will only be taken if a second move also seems necessary. That is likely to come in the September – November window, when the evidence that inflation has moved back to a benign pace will be even more apparent.

Bill Evans is Westpac's chief of economics.