WEEKEND ECONOMIST: Rates on hold for now

This week's economic data was surprisingly bad, but the RBA will need a bit more convincing that inflation is under control before it starts cutting rates in early 2009.

The Reserve Bank Board meets next week and the results of the meeting will be announced at 2:30pm on August 5. We do not expect to see any change in rates coming out of this meeting. Our view has been that the Bank will need to see a period of around twelve months when domestic spending growth is around a 2 per cent annual pace. That would be enough to ease demand pressures in the economy allowing inflation to make good progress in moving back within the target 2-3 per cent band by the end of 2010.

Our forecast (and we assess the RBA’s forecast) was that this slowdown would be apparent from the second half of 2008, allowing the Bank to begin cutting rates from late 2009 or early 2010. Unlike the slowdown in mid 1990s, when a comparable fall in inflation was achieved with a similar scale of slowdown, the 'responsibility' for the slowdown this time would be with the consumer rather than residential construction. Hence we have been expecting consumer spending to slow.

The July 31 retail sales report for June showed a contraction in real retail sales for a second consecutive quarter, including an extraordinary 1 per cent fall in nominal retail sales in the month and substantial downward revisions. The through-the-month trend points to another very weak result in the third quarter, although this may be offset to some extent by the tax cuts which consumers received from early July. That has prompted us to substantially lower our forecast profile for consumer spending growth.

The flavour of a sharper than expected slowdown was also apparent in the credit growth data which showed three month annualised business credit growth slowing to a meagre 3.7 per cent and three month annualised housing credit growth slowing to 7.8 per cent – the weakest since 1983.

Accordingly we have also moderated our profile for investment growth while recognising that part of this credit slowdown will be associated with balance sheet adjustments. Therefore we now see spending growth as having slowed more abruptly than earlier expected. We estimate that the final spending pace slowed to an annualised 1.6 per cent in the second quarter from 3.6 per cent in the first quarter and 5.9 per cent in the fourth quarter. We have also lowered our forecast of the pace of expected spending growth over the next year to 1-1.5 per cent annualised from nearer 2 per cent. Therefore it is appropriate to bring forward our estimated timing of the first rate cut in the easing cycle.

We now expect the first cut from the first quarter next year when the RBA will have clear evidence of this weak growth momentum and has had some chance to assess the impact on spending of the terms of trade boost. We also expect that the RBA will be encouraged by a faster than expected slowdown in underlying inflation providing more comfort to start the easing cycle.

The rate cut cycle is likely to extend into 2010 with a target low point of 5.5 per cent (from the current 7.25 per cent) in the first quarter of 2010.

Markets appear to believe that the RBA will adopt a much more negative view of the growth profile than our revised view and will convey that thinking in the Governor’s Statement following the RBA’s Board Meeting next week and its Statement on Monetary Policy on August 11.

That case would go along the lines of giving exclusive emphasis to the recent collapse in credit growth; recession levels of consumer and business confidence and the previously mentioned weakness in consumer spending. The additional tightening from the banks (50 basis points on mortgages) would also be seen as an important factor justifying that stance. The Bank will be careful to prepare markets for such a quick reversal in policy stance and that should become clear from those communications.

On the other hand, we still have the stimulatory effects of the terms of trade boom (note that net exports will add 0.3 per cent to GDP growth in the second quarter compared to a subtraction of 0.7 per cent in the first quarter). Recent quarterly reads of underlying inflation are running at a 4.4 per cent annualised pace. Lead indicators of employment growth point to a slowdown but not an employment crash. Measures of inflationary expectations – which the Bank has consistently highlighted as being significant to their thinking – remain highly elevated. Much of the recent consumer confidence weakness can be put down to petrol prices which have since started to fall.

However, even if the RBA communication points to an earlier beginning to the easing cycle than we currently forecast we will be unlikely to change our general assessment of the size of the overall move with a 5.5 per cent low point still in mind.

Currency view unchanged

Clearly an earlier-than-originally-expected beginning to the easing cycle should have implications for our Australian dollar (AUD) forecast. Markets have recently pushed AUD back to around $US0.9450. However our AUD view has always been mainly driven by our negative USD view. Markets have been expecting two rate hikes in the US by year’s end or early 2009. We see no moves and expect the US 'domestic recession' to deepen through 2008 and into 2009, particularly as labour markets weaken substantially.

Inflation can fall more quickly than the RBA currently forecasts

Our research suggests that in 2009 the Bank is likely to receive much better news on inflation than is currently forecast. That will also accommodate an earlier than previously expected rate cut.

Governor Stevens noted in a recent speech that underlying inflation could still be at 4 per cent in a year's time. The current RBA forecast for underlying inflation next June is 3.5 per cent. That is likely to hold at the next Statement on Monetary Policy (August 11) since the starting point for the forecast (year to June 2008) has increased from 4.2 per cent to 4.4 per cent but the expected growth profile has softened further.

As we pointed out in the Weekly note last week, that annual inflation rate could fall quite quickly in 2009. It already appears that underlying inflation has peaked in quarterly terms. The quarterly underlying measure has fallen from 1.2 per cent in the March quarter to 1.1 per cent in the June quarter.

Over the last year underlying inflation AND headline inflation have increased very quickly. A year ago, underlying inflation stood at 2.7 per cent and it has increased to 4.3 per cent (trimmed mean) in just one year.

Headline inflation has increased from 2.1 per cent to 4.5 per cent over the same period with 0.66 percentage points of the increase coming from deposit and loan facilities and 0.97 percentage points coming from petrol – 1.63 percentage points of the total 2.40 percentage point rise came from just two items.

Now, it is true that petrol and deposit and loan facilities have not contributed DIRECTLY to underlying inflation. However we assess that there has been a fairly hefty INDIRECT contribution. To test that, we built a model for annual trimmed mean underlying inflation. Instead of growing by 18 per cent (petrol) and 16 per cent (deposit and loan facilities) we simulated what underlying inflation would have been if those two items had grown by 3.9 per cent instead. Under those circumstances underlying inflation rose by 0.4 per cent less.

In short, while the trimmed mean measure takes out large volatile items, these items still have a substantial indirect effect on the trimmed mean, by bringing many more items with strong increases back into the trimmed distribution, extending the upper 'tail' of price changes.

Oil prices have recently fallen by 15 per cent. Banks are competing aggressively in the retail deposit market. It is not unreasonable to assume that petrol and deposit and loan facilities will not replicate anything like their double digit growth rates over the next year. That could be good for around a 0.5 per cent reduction in the annual trimmed mean. Components that we believe DID directly impact the rise in the trimmed mean were house purchase costs, rents, electricity, alcohol, other financial services and dining out. We have already seen a sharp fall in house purchase cost inflation on a quarterly basis, while other financial services and dining out are very likely to respond to softer demand.

In short, there is a decent case for expecting that annual underlying inflation could fall much more quickly than the RBA currently forecasts.

That would also allow the Bank to move more quickly than we had been expecting.

If current inflation is falling somewhat faster than currently forecast by the RBA then the growth profile will become the dominant factor. We still have not seen the impact of the 20 per cent boost to the terms of trade on spending. We know nominal income will increase by an additional 3 percentage points and this has been a significant boost to spending in recent years despite the narrow base of the resources sector. Of course one of the most important transmission mechanisms is through tax cuts and other forms of stimulatory fiscal policy. The government has indicated a commitment to tight policy but that was at a time when the market had two more rate hikes priced in.

With rate cuts now expected, a much more stimulatory fiscal policy next year in response to another huge improvement in the fiscal position (courtesy of the terms of trade boost) certainly cannot be dismissed.

Bill Evans is the chief economist at Westpac.

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