Weekend Economist: Over easy

The Reserve Bank can be reasonably assured its 'talking down the dollar' strategy is effective. Now the board will be forced to drop its easing bias.

The Reserve Bank Board meets next week on February 4. It is certain that the board will choose to keep rates on hold.

However, as we discussed in a note on January 23, the key to next week's decision will be the wording of the governor's statement and the forecasts which the bank releases on February 7 with its Statement on Monetary Policy.

The particular wording which has recently resonated with markets has not been used in the governor's Statement but has appeared in the minutes of the meeting published two weeks later. The wording, which has been used consistently in recent minutes, has been:

"... it was prudent to hold the cash rate steady while continuing to gauge the effects of earlier reductions, but not to close off the possibility of reducing it further should that be appropriate to support sustainable growth in economic activity, consistent with the inflation target".

Consequently it may not be possible to gauge definitively from the governor's statement whether this wording will be retained in the minutes, which will not be released until February 18.

A more timely guide on this particular theme will be available on February 7, when the SoMP will be released. In the November SoMP the following words were used in the overview: "... it was appropriate to hold the cash rate steady, but not to close off the possibility of reducing it further, should that be needed to support economic activity consistent with the inflation target". The likely absence of that theme in the overview to the SoMP will also be a clear signal that the bank has dropped its easing bias.

We expect that the governor will take a more direct approach by indicating clearly to markets in the governor's statement that the easing bias has been dropped. He could do that in the concluding paragraph which in recent statements has been quite bland: "the board judged that the setting of monetary policy remained appropriate". He could add "for the foreseeable future".

Alternatively he could sound less confident around the inflation outlook – in December he stated: "recent data on prices and wages show inflation consistent with the medium term target". Recognition of the 0.9 per cent print for underlying inflation in the December quarter and the associated heightened risks around the near term target would be sufficient to imply that the easing bias had been dropped.

For example, through the first half of 2013 he favoured the wording: "inflation outlook would provide scope for easier policy". He could note that while he remained confident about the medium term there were sufficient uncertainties around the near term inflation outlook that there was much reduced scope for easier policy in the near term.

The governor will not want to sound too hawkish with the associated risk of boosting the Australian dollar. He will be reasonably reassured that the 'talking down the Australian dollar strategy' has been somewhat successful. Recall that in the December Statement he noted: "the Australian dollar is still uncomfortably high". Since that meeting the Australian dollar has fallen from $US0.912 to $US0.88. He is likely to maintain that approach, with the higher inflation print not compromising his interest in a lower dollar.

In summary, we expect that he will not wait for the SoMP or the minutes to signal that the board no longer believes that the inflation outlook allows scope to ease policy in the near term. In effect the board will be forced to drop its easing bias.

That theme will be emphasised with the inflation forecasts which will be revised for the SoMP released on February 7.

Last week I wrote: "The December quarter Inflation Report surprised forecasters and markets. The Consensus view was for 0.5 per cent (core) and 0.6 per cent (headline) and the report printed 0.9 per cent core and 0.8 per cent headline.In the event annual core inflation has lifted from 2.4 per cent to 2.6 per cent and annual headline inflation has lifted from 2.3 per cent to 2.7 per cent.

“From the perspective of the Reserve Bank this means that whereas, in its November Statement on Monetary Policy, it could comfortably forecast core inflation as 2.5 per cent to June 2014; 2-3 per cent to December 2014; and 2-3 per cent to December 2015, the forecasts for the February Statement on Monetary Policy will need to be reassessed. The June 2014 forecast is likely to be lifted to 2.75 per cent, implying 0.6 per cent in both March and June quarters of 2014 with an outside risk of a 3 per cent forecast implying 0.75 per cent in both March and June quarters.

“If it opts for the 2.75 per cent forecast then it can comfortably retain the 2-3 per cent forecast for 2014. If it opts for the 3 per cent forecast to June then it might choose a 2.5 per cent-3.0 per cent forecast for December 2014. Either way it will retain the 2-3 per cent forecast in 2015. We favour the 2.75 per cent and 2–3 per cent option for 2014."

We do not expect significant changes in the growth forecasts. The key to the bank lifting its near term inflation forecast but maintaining the 2014 and 2015 forecasts is the evidence we have seen around wages growth. To the extent that a lower Australian dollar and higher government charges lift headline inflation, a sustainable impact on inflation will only be forthcoming if workers can extract higher wages to compensate. Consistent evidence around the soft labour market and the recent slowdown in wages growth points to workers' prospects of extracting compensatory wage increases being quite poor.

The associated demand effect of workers being squeezed points to a return to benign inflation and ongoing softening of wage pressures. Non tradeable inflation should start to evidence that effect – we expect that the Reserve Bank will also adopt that theme, discouraging markets from anticipating a sustained lift in inflation.