WEEKEND ECONOMIST: Levying growth

On February 1 the Reserve Bank Board meets for the first time since December 7. We confidently expect rates to remain on hold.

There are many reasons why the Bank will keep rates on hold.

Firstly, the effects of the rate hike in November and the subsequent larger increase in mortgage rates will not yet be clear. With rates now above neutral more time should be taken between rate moves to assess the impact. These lags are further complicated by the banks' raising mortgage rates further than the RBA raised the cash rate. From the start of December 2009 to end December 2010 the average variable mortgage rate increased by 150bps compared to a cumulative cash rate increase of 125bps.

Secondly, the floods will have a severe impact on economic activity in the first quarter. The Bank will need time to assess that impact.

In that regard the government has announced that growth in the 2010/11 fiscal year is likely to be 0.5 per cent lower than original estimates as a direct result of the floods impact on economic activity. In our note last week we estimated that the floods will reduce growth in the March quarter of 2011 from 1.1 per cent to -0.1 per cent while growth in the June quarter will increase from 0.9 per cent to 1.9 per cent. That profile was consistent with a growth rate of 0.35 per cent lower than "pre flood" profile.

The government's overall growth forecast for the first half of 2011 is consistent with a profile like -0.3 per cent (March quarter) and 1.8 per cent (June quarter). Hence the RBA Board is likely to be making its rate decision over the next few meetings with the expectation that the economy contracts in the March quarter.

Finally, the December quarter Consumer Price Index printed a much lower number than expected. There were some encouraging signs in the inflation report that soft demand and the high AUD are impacting deflationary pressures on demand sensitive goods and services – clothing down 1.9 per cent; household contents and services down 0.6 per cent; cars down 1 per cent. These moves can be mainly attributed to soft demand. The link between the AUD and retail prices is tenuous. We have found in other cycles that currency appreciations generally mean higher retail margins rather than being passed on unless retailers are forced to by weak demand.

Westpac does not expect to see the next rate hike until the September quarter although the stronger likely growth profile in the second half due to the rebuilding program points to upside rate risks in the second half.

RBA growth outlook

Next week, on February 4, the Bank will also release its Statement on Monetary Policy. Included in the Statement will be its table on the growth and inflation outlook.

Recall that in our analysis of the likely growth profile associated with the floods we raised our (through the year) growth forecast for 2011/12 from 3.5 per cent to 4.2 per cent and the 6 month annualised growth rate in the second half of 2011 from 3.4 per cent to 4.6 per cent. That was predicated on the government's contribution to the rebuilding process being funded out of debt.

The Prime Minister has now stated the government's intention to fund the $5.6 billion in commonwealth payments to the states and individuals from a levy on tax payers ($1.8 billion); rescheduled infrastructure spending ($1 billion) and abandoning other spending initiatives ($2.8 billion). If we adjust our spending profile for these initiatives and also lower our estimate of the extent of privately funded spending (due to revised estimates from industry as the picture has become clearer) we have lowered our (through the year) growth rate in 2011/12 from 4.2 per cent to 3.8 per cent. We have also lowered our forecast for the annualised growth rate in the second half of 2011 from 4.6 per cent to 4.2 per cent. This is still a very brisk rate of growth which can be expected to lower the unemployment rate to around 4.6 per cent and represent upside risks to interest rates.

The Reserve Bank's forecasts are currently for through the year growth in 2011/12 of 3.75 per cent. The Bank's current forecast for annualised growth in the second half of 2011 is 4 per cent compared to our "pre flood" forecast of 3.4 per cent. If the Bank has a similar change profile for "post flood" to our own assessment it will now be forecasting 6 month annualised growth rate in the second half of 2011 of around 5 per cent. Of course that is before any further upward adjustment is made to the Bank's base profile because of the much higher terms of trade levels since the last forecasts in early November (spot iron ore price up 24 per cent; coking coal up 55 per cent; Westpac's commodity futures Index, which excludes iron ore and coal, up 10 per cent).

Based on that analysis the Bank is likely to be raising its growth forecast in 2011/12 from 3.75 per cent to at least 4 per cent while reducing its forecast for 2010/11 from 3.5 per cent to 3 per cent. Needless to say if we have a Bank which assesses NAIRU at around 5 per cent (current level for the unemployment rate) and is expecting growth in the order of 5 per cent in the second half of 2011 and at least 4 per cent in 2011/12 then it will have a very specific tightening bias.

The impact of these revised growth forecasts on the inflation forecasts will be interesting. The Bank has the advantage that the "starting point" for underlying inflation is lower than expected in November. Annual underlying inflation in 2010 fell to 2.2 per cent – below the Bank's forecast of 2.5 per cent. At present the Bank expects the annual rate to increase by just 0.25 per cent between 2010 and 2011.

Whether the Bank changes its forecast that inflation will increase by only 0.25ppts in 2011 will depend on its assessment of the lags between growth and inflation. It will certainly look through any "one off" effects on food prices from the floods. A soft growth patch in the first half of 2011 is likely to ensure that inflation still only increases by 0.25 per cent through 2011. That will have underlying inflation in 2011 being lowered from 2.75 per cent to 2.5 per cent.

However, strongly accelerating growth in 2011 is likely to be assessed to put more pressure on inflation in 2012. Currently inflation is forecast to rise by 0.25ppts in 2012 from 2.75 per cent to 3 per cent.

With the lower starting point it is reasonable to lower the forecast for inflation in 2011 to 2.5 per cent but raise the pace of increase to 0.5ppts in 2012, thereby leaving forecast inflation unchanged at 3 per cent.

Such a forecast inflation profile would imply that the tightening bias, which the Bank held prior to the floods and the surprise low inflation print, is still in place.

Bill Evans is Westpac's chief economist.