Weekend Economist: Flat track rates

All the attention on whether rates will move up or down next ignores the reality that they won't move in either direction for some time.

The Reserve Bank board next meets on August 5. There is almost no chance that any policy change will result out of the meeting.

Recall the concluding paragraph in the governor's statement following the last board meeting on July 1, "On present indications, the most prudent course is likely to be a period of stability in interest rates".

At that time markets were pricing in a probability of around 40 per cent for a rate cut by February 2015 with little chance of a rate hike until 2016.

Subsequently, from early July markets became more confident that the next move would be down. By July 4 markets had lifted that probability of a downward move by February 2015 to around 60 per cent.

That pricing was mainly in response to the weak retail sales report for May (printed on July 3) which showed that retail sales had contracted by 0.5 per cent in May following a downwardly revised -0.1 per cent in April (from 0.2 per cent) and a flat read for March. In particular, two key factors were impacting that very weak result: the collapse in consumer confidence in response to the May federal budget, which followed consumer trepidation in the lead up to the budget as the government implied a particularly tough set of savings initiatives. We also assess that an unusually warm May affected department store and clothing sales in the month (around 0.3 percentage points of the 0.5 per cent decline).

On that day, the governor spoke in Hobart and made an impassioned plea for a lower Australian dollar, describing it as overvalued by more than a few cents.

The jump in "rate cut" probability pricing was largely driven by that retail sales report and, to a lesser degree, the governor's speech. The actual level of the Australian dollar remained within the US dollar 0.93-94 range.

However, pricing moved back to around a 35 per cent probability of a rate cut by February in response to the higher print for the June quarter CPI. Consensus forecasts were 0.6 per cent for underlying inflation while the "market whisper" number appeared to be closer to 0.5 per cent. In the event, the 0.7 per cent print significantly hosed down expectations for a rate cut - and for good reason.

The 0.7 per cent print followed a "noisy" period where underlying inflation printed away from expectations (at 0.9 per cent for the December quarter and 0.5 per cent for the March quarter). The Reserve Bank pointed out that the best way to assess that period was the average move of 0.7 per cent per quarter. So, underlying inflation appears to have entrenched a 0.7 per cent quarterly pace (2.8 per cent annual) which is in the upper half of the Bank's target range and hardly conducive to rate cuts or easing biases.

We are left with a "period of stability" as the most likely description of the policy outlook for the governor's statement on August 5.

The description of the Australian dollar is also likely to be unchanged. As we have discussed in recent notes it has become clear that unless the bank is prepared to adopt an easing bias the use of "strong language" around the Australian dollar is unlikely to have any impact.

We expect that the same language will be used as in recent statements: "The exchange rate remains high by historical standards, particularly given the declines in key commodity prices, and hence is offering less assistance than it might in achieving balanced growth in the economy".

Note how the governor of the Reserve Bank of New Zealand strengthened his language around New Zealand dollar to "unjustified and unsustainable and there is potential for a significant fall" but complemented the language by signalling a pause in the rate hike cycle - New Zealand dollar fell from  $US0.87 to $US0.85 in the aftermath.

The Reserve Bank will also be releasing its August statement on monetary policy on August 8. This document is most significant from the perspective of the bank's growth and inflation forecasts for 2014; 2015; and 2016.

In the most recent SOMP, released in May, we only received forecasts out to June 2016. But the August SOMP will also include a forecast out to end 2016.

In the most recent statement, the bank forecast GDP growth in 2014 at 2.75 per cent; 2015 at 2.75–3.75 per cent; and 2.75 per cent–4.25 per cent to June 2016.

Underlying inflation was forecast at 2.5 per cent for 2014 and 2–3 per cent for 2015 and to June 2016.

For inflation the most interesting numbers are the 2014 and June 2015 forecasts – the 2014 gives us a guide on their forecasts for inflation in the second half of 2014 while the June 2015 forecast gives us their 1 year outlook.

Beyond that the bank is always likely to retain the bland 2-3 per cent forecast, indicating that it does not expect to miss its policy target.

With the first half of 2014 printing 1.2 per cent on underlying inflation, maintaining its current 2.5 per cent for 2014 implies the bank is expecting an "average" pace in the second half of 2014 of 0.65 per cent per quarter (down from the 0.7 per cent in the first half - see above). This is likely to be achieved by a modest (0.1 per cent) impact from the repeal of the "carbon tax" mainly affecting the September quarter. After adjusting for the likely effect of the carbon tax on underlying inflation the Bank's maintaining 2.5 per cent for the year to 2014 implies it is expecting the current run of prints of 0.7 per cent per quarter to be sustained for the second half of 2014.

Recall that the bank lowered its 2015 GDP growth forecast in the May SOMP from 3–4 per cent in February to 2.75–3.75 per cent in May. That decision was largely the result of a rise in the Australian dollar between February and May from $US0.89 to $US0.93 and a rise in the TWI (trade weighted index) from 69 to 71. Since May there has been no significant change in the Australian dollar. It is likely that the forecasts for the August SOMP will use the same Australian dollar forecasts as were used in May.

For that reason it is likely to maintain its forecast for 2015 at 2.75– 3.75 per cent. That pace is around trend and therefore implies no pressure over the course of this year to adjust policy.

Current forecasts imply a lift in the momentum of growth from 3 per cent in first half in 2015 to 3.5 per cent in second half and first half in 2016.

It would also imply that the bank does not expect the recent slowing in consumer spending is likely to be sustained in 2015.

The growth rate for June 2016 was forecast at 2.75- 4.25 per cent in the May SOMP. That implied an assumption of 1.75 per cent for both 2015 second half and 2016 first half. It is likely that the above trend assumption will be retained for 2016 second half leading to the same forecast of 2.75 per cent - 4.25 per cent for 2016.

The profile for the various quarters in 2014 is more problematic. With the strong 1.1 per cent for first quarter 2014 having printed, retaining 3 per cent for the year to June 2014 would imply an expectation of 0.5 per cent for the second quarter. That is slightly below our forecast of 0.6 per cent but given the downside risks around the consumer and net exports looks to be a likely call by the bank.

The bank is currently forecasting 2.75 per cent growth for 2014. With 1.6 per cent expected for the first half, that assumes 1.2 per cent for the second - a series of 2 x 0.6 per cent or 0.5 per cent and 0.7 per cent. That assumption of a very soft patch in second quarter and third quarter looks a little extreme but given the loss of momentum in second quarter seems reasonable.

From a policy perspective, the bank might receive some criticism that in forecasting two consecutive quarters of significantly below trend growth begs the question as to why policy is not being eased further. However, from a monetary policy perspective the key growth forecasts are in 2015 given that policy acts with a lag. In that regard, the bank will be forecasting a return to trend growth and therefore no need for a policy change.

Overall, therefore, we expect the growth forecasts in 2014, 2015 and 2016 to be unchanged with the stronger 2014 first quarter number being offset by weaker growth in 2014 second quarter and third quarter reflecting the weakness in the household sector partially in response to the commonwealth budget.

Bill Evans is chief economist with Westpac.

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