Interest rates will be on hold again this month and upwardly revised growth forecasts mean that the two cuts expected in the December quarter may no longer be likely.

The Reserve Bank board meets next week on Tuesday. We are extremely confident that there will be a "no change" decision.

On July 17, following the release of the board minutes for the July board meeting it was clear to us that the board was firmly in a "wait and see" mode for quite a few months. We still believed that the eventual case for further rate cuts would be strong but deferred the first move to October/November.

At that time the market was pricing in an August rate cut with a 50 per cent probability; an almost certain probability of two cuts by October; and a total of four cuts by March.

We viewed that pricing as excessive making the observation that market pricing was a mix of monetary policy expectations and a "safe haven" premium. With a continuation of the flow of better than expected domestic data market pricing has now reverted to two rate cuts by November with a third by March next year.

With the strong likelihood that the "safe haven" will still be a component of market pricing we can only conclude that market based monetary policy expectations are less aggressive than our own position which expects three rate cuts by March next year with two in the December quarter.

Prospects of this outcome are currently severely affected by the recent strong data flow around consumer spending. Retail sales volumes are reported to have increased by 1.4 per cent in both the March and June quarters. Of course the impact of that retail lift was felt in the March quarter where overall real consumer spending (retail is around 40 per cent of total consumer spending) was reported to have soared by 1.6 per cent.

That is likely to be revised down somewhat with the downward revision of real growth in retail sales in the March quarter from 1.8 per cent to 1.4 per cent.

However, the results have certainly surprised us given the downbeat confidence of both consumers and retailers in the Westpac Melbourne Institute Index of Consumer Sentiment and various business surveys. To put these results in perspective: volumes growth of 2.8 per cent in the first two quarters is double the growth seen over all of 2011 and is tracking the 5 per cent annual pace in trend terms – around the average seen in the decade prior to the Global Financial Crisis when retail spending was being fuelled by household leverage. Of course comparison with that pre GFC period falls down when considering nominal growth in retail sales which was about double the nominal pace in the first half of 2012.

Moderate nominal growth probably explains part of the low confidence of retailers since it has not been possible for retailers to take advantage of this buoyant consumer behaviour by raising prices (the price deflator for retail fell by 0.6 per cent in first quarter and was flat in the second quarter). In effect households have not adjusted their nominal behaviour to take into account low prices – boosting volumes without increasing nominal expenditure. There will also be an element of spending in response to the income boost associated with the rate cuts and the one off fiscal payments which were received in the June quarter (we estimate a total boost of $3 billion in incomes over that period). Consistent with the temporary impact of the one off fiscal payments (around $1.9 billion) there were strong sales in food and small ticket discretionary items whereas household goods were declined 0.8 per cent over the first half of 2012.

The strong print for GDP growth in the March quarter coupled with the strong growth in retail volumes in the June quarter are likely to see forecasters significantly upgrade their growth forecasts for 2012 with a more robust story for consumer spending.

We also saw a sharp improvement in the trade position with a trade deficit of $2.7 billion in the March quarter being followed by a much improved $0.3 billion deficit in the June quarter. We estimate that such an improvement implies strong export volumes growth in the June quarter of 5 per cent, more than reversing a 1.3 per cent decline for the first quarter.

With such adjustments we now expect that the June quarter GDP growth print will be around 0.8 per cent up from the 0.3 per cent we expected before the export and retail sales data was available. That will mean annual GDP growth through to the June quarter of around 3.5 per cent – certainly down from the 4.3 per cent which printed for the March quarter but well up on the 2.5 per cent for calendar 2011.

Of course the RBA will be assessing these data developments when it releases its revised growth forecasts out to June 2014 in its August Statement on Monetary Policy, to be released on August 10.

In the May statement, which followed the surprise decision to cut rates by 50 basis points three days earlier and preceded the decision to cut by a further 25 basis points following the June board meeting the forecasts were decidedly downbeat. Through the year growth to the June quarter 2012 was forecast at 2.75 per cent. That compares with our revised forecast of 3.5 per cent and we expect that the bank will adopt a similar upgrade, if not moving even higher to 3.75 per cent. For the year of 2012 we expect a reasonable forecast would be 3.5 per cent, year average, up from the 3 per cent in the May statement but forecasters would probably not disagree with a number as high as 3.75 per cent.

The growth forecasts for 2013 will also be relevant. The issue will be whether the RBA is prepared to accept that the recent surprising strength in consumer spending can be sustained through another year. Our view is that this is unlikely to be the case since we expect a slowdown in jobs growth and rising unemployment. On the assumption that the "non wage" boosts to income growth (as we saw in 2012 first half) will be limited to lower interest rates, we would expect consumer spending growth to fall back from the robust 4 per cent pace during 2012 to around 3 per cent in 2013. Nevertheless it is likely that the bank will raise its growth forecast for December 2013 from 2.5 per cent – 3.5 per cent (in May) to 3.5 per cent.

Of course, the significance of these changes would be that the RBA would no longer be in the "below trend" growth mindset which we saw in May. It will have moved back into the "around trend" mindset which we saw in February, where it was forecasting growth of 3 to 4 per cent for 2013 – the same forecast which we expect to print next week.

Those "around trend" growth forecasts are synonymous with a "no policy change" stance. The downward revision to growth in May was prompted by weaker than expected growth for the December quarter which printed in early March. We do not expect a comparable shock for the June quarter which might affect the growth forecasts in the November statement. However, a more troubling employment and global picture, coupled with an improved set of inflation forecasts, could be used to justify lower rates by the time of the November statement. Note, we expect the underlying inflation forecast (in both the August and November Statements) for 2012 to stay at a low 2.25 per cent, compared to 2.75 per cent in February, and that the forecast to June 2013 will be 2 to 3 per cent, compared to the 2.75 per cent published in February.

Bill Evans is Westpac's chief economist.


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