Weekend Economist: Inflated expectations

The Reserve Bank has raised its forecasts for growth and inflation in its February Statement on Monetary Policy. The key changes for GDP are: growth to December 2013 up from 2.25 per cent in November to 2.5 per cent in February; growth in 2014 up from 2-3 per cent in November to 2.25 per cent-3.25 per cent in February. For underlying inflation: to June 2014, up from 2.5 per cent in November to 3 per cent in February; to December 2014, up from 2-3 per cent in November to 2.25 per cent-3.25 per cent in February.

The revised growth forecasts are in line with our expectations.

The bank notes that they are singularly reflecting the choice of a lower Australian dollar, now around $US0.89, down from $US 0.95 in November. This is considered to provide a modestly greater boost to net exports than envisaged in November. Significantly, there is no change to the forecast for domestic demand.

We are surprised with the decision to boost the inflation forecasts to this degree. We were expecting the June 2014 forecast to be raised to 2.75 per cent and the December forecast to remain at 2-3 per cent. As expected, the December 2015 forecast has been retained at 2-3 per cent.

With the first two quarters of the year ending June 2014 already printing 1.5 per cent, the bank is likely anticipating prints for the March quarter of around 0.8 per cent and the June quarter of around 0.7 per cent. This is because it assumes that the forces boosting the December 2013 print for underlying inflation from 0.6 per cent in September to 0.9 per cent in December are expected "to persist somewhat early into this year" in conjunction with the further depreciation of the exchange rate since November. With the Australian dollar already back around $US 0.90, this assumption seems somewhat vulnerable.

The lift in the December 2014 forecast to 2.75 per cent is not so surprising once the June 2014 assumption is in place. Under our expected forecast profile, the implied prints in the September and December quarters were the same as the bank's underlying assumptions – around 0.6 per cent-0.7 per cent per quarter.

It even appears that the bank is a little uncertain with its inflation forecast profile for the next two quarters: "It could be that there was a higher than usual degree of noise in the data which can occasionally occur owing to difficulties of measurement or the timing of price changes. This would imply that the higher than expected inflation recorded in the quarter will not persist." The bank also questions whether the inflation surprise could be explained by "some strengthening in demand in recent months that enabled firms to increase prices" by noting that its liaison does not point to a broad based increase in demand. Alternatively it could be because supply is increasing more slowly than previously thought, but that is hard to reconcile "with the weak state of the labour market."

In effect, by retaining its forecast pace of inflation pressures in the second half of 2014 and its forecast for 2015 of 2-3 per cent the bank is continuing to rely on the impact of slow wages growth to contain any upward pressures on inflation from the depreciation of the Australian dollar. In its thinking, the bank expects these downward pressures on wages to be sustained for some time," exerting mild upward pressure on inflation for several years".

A curious aspect of the bank’s 2015 view is the forecast for underlying inflation for the year to June 2015 holding at 2.25-2.75 per cent. Based on the 2014 forecast, this implies that, in the first half of 2015, quarterly inflation will average around 0.75 per cent per quarter. In turn, the December 2015 forecast of 2.5 per cent (mid-point of the 2-3 per cent forecast range) implies inflation in the second half of 2015 averaging 0.5 per cent per quarter. This profile seems inconsistent with the growth profile which implies strengthening through 2015. It is consistent though with a high degree of uncertainty around the inflation outlook.

As discussed above, the bank has not changed its overall thinking on the dynamics of the Australian economy. Headwinds are expected from the sustained slowdown in mining investment and fiscal consolidation. The current surge in house prices and expected boost to residential construction is expected to boost consumer spending, which will be supplemented by a moderate fall in the savings rate. Businesses are expected to respond to the improving outlook for final demand by moderating their current "focus on reducing costs and raising productivity; uncertainty causing a reluctance to employ new workers" and raising employment and investment plans. But this key development is expected to take time and during that period the unemployment rate is still expected to drift upwards. Global risks are broadly balanced, with upside risks for the US economy offsetting any renewed concerns around the emerging markets.

On face value, the evidence of a central bank forecasting that underlying inflation will reach the top of the target band should be very disturbing, especially for markets. But that forecast, from our perspective, appears to be overly ‘conservative’ – i.e. the 0.8 per cent rise in underlying CPI implied for the March quarter looks too strong, we expect it to be 0.6 per cent. Importantly, the forecast profile for the second half of 2014 and 2015 is unchanged with the bank, reasonably, maintaining the view that the softening of wage pressures will offset any lingering effects of the fall in the Australian dollar. Furthermore, we detect a degree of concern in the bank that the signal from the December quarter might be overstated.

There is no surprise around the proposed dynamics of the Australian economy – they are unchanged from the November Statement with the modest upgrade to the growth forecasts coming mechanically from the lower exchange rate and no change to the domestic demand forecast.

This is therefore not a Statement that should see markets reading any indication of a likely rate hike. In fact, our view that rates can come down in the second half of 2014 can be put in perspective by challenging some of the assumptions around the bank's assessed dynamics of the economy. More entrenched reluctance from business to invest and employ than expected by the bank will take pressure off rates; ongoing caution from the consumer without the expected fall in the savings rate will contain the bank's forecast for the boost to final demand; a more difficult global economy than envisaged by the bank would also threaten the bank's expected dynamics.

It is notable that the Statement notes in the key introduction: "At present, market pricing suggests no change to the cash rate is expected for about a year". It seems clear that the dynamics set out in the Statement are consistent with that view.

We continue to see the case for lower rates in the second half of 2014, while recognising the range of uncertainties.