For the first time, the RBA has supplied their growth forecasts in fiscal year average terms to allow a direct comparison with the Government's MYEFO forecasts which were delivered earlier this week. The table below shows that the forecasts are broadly consistent, with the Bank being a little more optimistic in 2010/11.
As expected, the Bank has also revised up its forecasts for underlying inflation in 2010 and 2011. The August forecasts indicated 2 per cent for both years (the bottom of the 2 per cent to 3 per cent target band) while the new forecasts have 2.25 per cent in 2010, rising to 2.5 per cent in 2011. Significantly, they have maintained their forecast for 2009 at 3.25 per cent despite core inflation to the September quarter being 3.5 per cent. With 0.7 per cent dropping out from the December quarter 2008, that means that quarterly underlying inflation will need to drop from the 0.8 per cent pace we have seen in the last two quarters, to around 0.5 per cent in the December quarter.
The Bank is placing a deal of emphasis on the rise in the currency to achieve this. That 3.25 per cent number for 2009 is quite important because it means that the 2.25 per cent forecast for 2010 requires a 1 percentage point fall in the underlying inflation rate over the year, with the high currency and spare capacity being identified as the key drivers.
Historically, a fall of 1 percentage point in underlying inflation has really only occurred in the aftermath of a recession. Given that the Bank's forecasts clearly indicate that Australia has and will comfortably avoid a recession, this forecast is a decent stretch, and will look even more vulnerable if core inflation finishes 2009 nearer 3.5 per cent (requiring a greater fall through 2010). Overall, we don't believe that the 2.25 per cent will be achieved in 2010 unless the "gradual tightening" picks up pace.
The fluctuating sentiment that we have seen over the last month covering two Statements from the Governor, one Governor's speech, and the October Board meeting minutes, seems to have now settled down to asserting the key word "gradual". In the key introduction section of the SoMP, the key policy sentence is: "The cash rate remains at a low level, and a further gradual [our emphasis] lessening of monetary stimulus is likely to be required over time if the economy evolves broadly as expected".
This concept of a gradual increase in the cash rate is also embedded in the growth and inflation forecasts. On face value, we are left with little doubt in this document that the Bank plans to adopt moves in 25 basis point increments, rather than the more bold policy that seemed consistent with the much more hawkish language in the Governor's speech of October 15, and the October Board meeting minutes. Commentary on the economy is generally positive.
We were interested in how the surprise fall in September retail sales may have been considered, but consumer spending is described as "spending has held up reasonably well, supported by high levels of consumer confidence and rising household wealth from higher asset prices". House prices are recognised to have strengthened considerably, and recoveries in housing construction, business investment and exports are expected to support the higher growth forecasts. The immediate outlook for the labour market is balanced with "tentative signs that the demand for labour is picking up again". A notably upbeat feature of the commentary on the domestic outlook centres around business investment, particularly in the resource sector.
In the "Risks" section of the Economic Outlook chapter, the Bank notes that: "Domestic investment in the resources sector could also prove to be significantly stronger than in the central forecast, in which it is assumed that not all currently planned projects proceed." They note of this upbeat investment outlook "as it takes place, short-term capacity constraints could again emerge in parts of the economy".
This is the key upside domestic risk highlighted: "...the higher level of investment spending and flow-on to the broader economy could see capacity pressures re-emerging in the near term... . In this event, underlying inflation would be expected to decline by less than in the central forecast." The observations supporting the historically large fall in underlying inflation which the Bank is forecasting rely mainly on the slowing in wage growth (with some further slowing expected) and the sharp appreciation in the currency. The growth and inflation forecasts are on the assumption that the AUD remains at current levels.
Consistent with other communications from the Bank, the China/Asia story is seen to be a major positive for Australia, with export growth expected to support growth, and "the outlook for Australia's terms of trade has also improved, with some increase now expected over the year or so." Given the huge boost to incomes from the rise in the terms of trade between 2005 and 2008, which has been followed by a "modest" fall of 20 per cent, this is a very optimistic assessment of Australia's income prospects. These forecasts are consistent with Westpac's own view.
For the immediate policy outlook, the Bank has not really provided any additional clues, apart from confirming the "gradual" policy approach that was indicated in the Governor's Statement this week. That's important because over the course of October, we did not get two consecutive communications that used "gradual" and therefore, were left in some doubt as to whether that approach has been abandoned. We expect that "gradual" will be part of the Bank's policy stance for some time.
In describing the upside risks to the outlook that might require a more immediate response, the two areas discussed are a more rapid than expected recovery in the developed economies, and a larger surge in investment, commodity prices and therefore incomes, associated with the resources sector. That would see the Bank's thinking returning to the catharsis of 2007. We see no reason from this SoMP to change our view that there will be another 25 basis point rate hike in December, with a view to the cash rate peaking around 4.5 per cent around mid-2010, to be followed by an extended pause as households and housing prove to be sensitive to even this gradual tightening.
Bill Evans is chief economist at Westpac.