Weekend Economist: Fragile China

As we expected, the Reserve Bank made minimal changes to their growth and inflation forecasts in the November statement on monetary policy (SoMP). They retained the call that growth to December 2014 would be 2½ per cent; to December 2015 would be 2½-3½ per cent; and to December 2016 2¾-3¾ per cent. On the inflation front underlying inflation is still forecast at 2¼ per cent to December 2014 and 2¼-3¼ per cent to December 2015. There has been a modest lift in the inflation forecast to December 2016 from 2-3 per cent in August to 2¼-3¼ per cent in this November SoMP. The RBA attributes that slightly higher inflation forecast to the lower Australian dollar which is used in the November forecasts. Specifically, the forecasts are based on an Australian dollar trade-weighted index of 68 and US dollar 0.86. That compares with TWI 72 and USD 0.93 in August. The key exchange rate for the forecasts is the TWI which is assessed as 4½ per cent lower than in August. 

As we noted in our preview we expected that the lower exchange rate forecast would boost underlying forecasts for net exports but there would be a substantial offsetting effect from the assumed fall in the terms of trade. That comes about as a result of the assumption in August that iron ore and coal prices would remain close to their current levels whereas we have seen substantial falls since then. Overall, the RBA has revised down its forecast for the terms of trade by around 2½ per cent leading to an expected fall of around 4 per cent over the rest of 2014 and early 2015. Weaker terms of trade weigh on national income and expenditure and it is this effect that is seen to offset the boost from the lower Australian dollar. The RBA notes that the net effect of these factors would provide “a small boost to GDP in the near term” but this boost is offset by a downward revision to business investment specifically related to weaker expected growth in non-residential construction. 

If we scrutinise the near term growth and inflation forecasts the following pattern emerges: the RBA is expecting GDP growth in the second half of 2014 to be only 0.9 per cent, an average quarterly print of 0.45 per cent. That is expected to lift to average quarters of around 0.8 per cent in the first half of 2015. 

We were a touch surprised that underlying inflation is still forecast at 2¼ per cent for 2014. That implies a 0.5 per cent print for underlying inflation in the December quarter. That is expected to lift to a 0.7 per cent pace in each of the four quarters of 2015. 

There are some significant changes in the RBA's assessment of the overall economic environment and the risks. On the international front, the rhetoric around Europe is softened from “gradual recovery” to “recovery expected to be modest”. The outlook for the US is unchanged but the commentary on China is different, specifically, the RBA now notes that “GDP growth [in China] in 2015 and 2016 is expected to trend gradually lower”. While in August the RBA allocated 13 lines to discussing its concerns around the Chinese housing market, the November report lifts the coverage to 34 lines highlighting the significant risks to Australia's economy and terms of trade of a “protracted decline in the Chinese property market”. Clearly that scenario does not figure in the RBA's central view but its commentary does not include a convincing discussion as to why these risks may be overstated.

On the domestic economy some familiar themes are repeated around a likely wealth effect to boost consumer spending (an implied fall in the savings rate) with an interesting observation that consumer spending has been at its strongest in the states of NSW and Victoria where house price appreciation has been the most rapid. It is also noted that stronger house price appreciation in the other states might therefore provide a more widespread boost to consumption. Indeed it comes as a mild surprise that the discussion in the “Uncertainties” section does not provide strong language around the risks of rising house prices and excessive leverage.

The views around the labour market are little changed with the unemployment rate being described as elevated, the participation rate as low and wages growth as low. In August however it was specifically speculated that there would not be a period of sustained decline in the unemployment rate until 2016. In this note that timing is described as “not expected for some time”. Arguably that choice of language provides a little more optimism around the labour market outlook than before. Certainly from our perspective we expect improving conditions to evolve before 2016.

The RBA has taken a modest backward step in its assessment of the strength of non-mining business investment: “a slight reduction in the strength of the forecast recovery in non-mining investment” particularly weighed down by non-residential building approvals and spending intentions for buildings & structures from the Capex survey. 

Despite the fact that there has been little change in the RBA's forecasts there are some interesting nuances in this statement. Firstly, we have noted over the last few statements a real evolution in the attitude towards China. Earlier in the year the RBA took a fairly complacent attitude to risks in China whereas now the decision to provide such a detailed assessment around the risks associated with the housing market is worth noting. The housing market has clearly been on the RBA's radar screen for some months now given that they dedicated a “fact-based” specialist report in the August statement without highlighting the risks in the same way.

Secondly, the discussion around household leverage and house prices appears to be less alarmist than we have seen in recent months with the wealth effect of house prices being highlighted as a potential boost to consumer spending growth which is still described as “modest” in the near term. Indeed the justification for the assumptions of an above trend outlook for consumer spending growth relies on falls in the savings rate.

The fall in the Australian dollar which the RBA uses for these new forecasts has clearly been very timely. With the need to further reduce the terms of trade forecast by 2½ per cent, no fall in the Australian dollar would have required the RBA to further lower its growth forecasts which are already below trend for both 2014 and 2015.

Key themes around the timing of the expected lift in non-mining investment and a sustained recovery in the labour market remain fairly fluid. The RBA really has not received any additional data since August to be able to express any more confidence about the timing of those key macro developments.

Monetary policy works with a lag of around 12 months. Consequently it is the RBA's forecasts for growth and underlying inflation in 2016 that should be signalling their current assessment as to whether it will be necessary to tighten policy in the second half of 2015 – our current forecast. In that regard the RBA continues to provide some wide forecast ranges. For growth, the range is 2¾-4¼ per cent in 2016 and for inflation 2¼-3¼ per cent (increased from 2-3 per cent in August due to the lower trajectory for the Australian dollar). If those numbers were assessed over the course of the next 6 months or so to be favouring the upper range of those bands then the RBA would be preparing itself to tighten policy. At the moment of course they continue to refer to “a period of stability in interest rates” and based on the 2015 forecasts that seems entirely appropriate. Over the course of the next 6 months those 2016 forecasts will begin to be tightened up and the direction of interest rates will be determined accordingly. 

We remain comfortable with our expectation that the next move in rates will be up but not until the September quarter of 2015.

Bill Evans is a chief economist at Westpac.