In its May statement on monetary policy the Reserve Bank has substantially reduced its inflation and growth forecasts. The overall tone of the statement has changed significantly with deflation and growth risks being emphasised. The implied case for further rate cuts is strong and it now appears likely that the board will be seriously considering further rate cuts at every board meeting for at least most of the course of 2012.
In the February SoMP, the bank forecast underlying inflation in the year to December 2012 at 2.5 per cent. That has now been reduced to two per cent. Forecasts to December 2013 appear to be broadly unchanged with 2.5 per cent being replaced by two to three per cent. The forecast for June 2014 has been reduced from 2.5–3.0 per cent to two to three per cent.
We find these forecast revisions significant since it is very rare that a central bank would forecast inflation at the bottom of the band over the course of the current year. On our figuring the bank is assuming a print for underlying inflation in the second quarter of 0.7 per cent falling to an average of 0.5 per cent in the third and fourth quarters. The other significant development is that there is no longer concern that inflation will necessarily reach the top half of the two to three per cent band in the year to June 2014.
In February the bank predicted that GDP growth in the year to December 2011 would be 2.75 per cent. The number subsequently printed at 2.3 per cent. That implies that the 0.4 per cent print for Q4 was being anticipated by the bank to be around one per cent, a large miss and the real catalyst for the bank's more dovish rhetoric over the last few months. Growth in 2012 is now forecast to be three per cent, down from the 3.0–3.5 per cent we saw in February. Growth in 2013 is now forecast at 2.5–3.5 per cent, down from the upbeat three to four per cent in February.
These substantial revisions to inflation and growth are despite the bank having cut the cash rate by 50 basis points since February. In the February SoMP the assumption around interest rates was "no change", and despite markets currently expecting a further series of rate cuts totalling 75bps, the bank's forecasts assume no change in the cash rate.
It is Westpac's view that growth through 2012 will be three per cent, consistent with the RBA's forecast, but our forecast relies upon a further series of rate cuts totalling at least 50bps.
The bank's decision to forecast underlying inflation (excluding the carbon price) to remain at the bottom of the two to three per cent band over the course of 2012 is a very strong signal that it retains an easing bias.
Since 2005, when the bank began publishing inflation and growth forecasts, there have only been two SoMP's when it has forecast inflation to be at the bottom or below the band over the next year or so. That was in May and August 2009 in the aftermath of the global financial crisis. Admittedly, the cash rate had bottomed out by then, but cuts totalling 425bps had been rapidly delivered as the economy lost momentum. In this current episode the bank's growth forecasts are more upbeat, but in recognising that inflation will remain at the bottom of the band (despite trend growth) the signal is clear that there is ample scope for further monetary easing.
The tone of the discussion around the economy is now consistent with the key themes that Westpac has been signalling over the last year.
Our themes have been around the impact of the high exchange rate on job prospects in industries such as manufacturing, retail and tourism, compounded by the deleveraging by the household sector with falling house prices and resulting concerns for job prospects and financial security for households. These forces have conspired to generate weak confidence, soft spending and falling construction activity. This in turn has pressured jobs and generated deflationary pressures. Furthermore, we have consistently questioned the strength of the so-called 'mining multiplier' and this SoMP seems to be consistent with reduced enthusiasm for the short- term stimulatory effects of the mining boom.
There is specific recognition of subdued housing activity, which partly stems from poor sentiment regarding job security, softness in existing housing markets and relatively tight credit conditions for developers. While it is recognised that the mining sector has been responsible for adding a substantial number of jobs, weakness in other sectors is now being recognised. The bank notes caution about hiring and that many firms are indicating they will need to reduce staffing levels to improve productivity and competitiveness. It is recognised that outside of the mining industry, growth in labour demand remains subdued. Indeed employment growth is now expected to remain subdued in the near term.
Furthermore, the assumed high level of the exchange rate and a weak short-term outlook for building construction are expected to result in subdued growth outside of the mining sector in the near-term. There is some attention given to public demand, which is now expected to decline over the year ahead consistent with the fiscal consolidation plans being signalled by both federal and state authorities.
The bank continues to expect a strong boost to labour demand from the mining sector although this is now described as "over the medium-term" as mining projects progress towards the labour intensive phase of construction.
Concerns around the European impact on the international economy are further emphasised and the global economy is still expected to grow at a below trend pace in 2012.
The governor's explanation of the decision to cut rates by 50bps on May 1 is repeated in this statement. The need for financial conditions to be easier than those which prevailed in December is emphasised. Recall that in February–March banks raised their variable mortgage rates by nine to 12bps. The implication is that the Reserve Bank would not be confident that a 25bp rate cut would lead to a reduction in private borrowing rates of more than nine to 12bps. We have now seen three major banks reduce their mortgage rates by an average of 36bps, suggesting that this response was greater than the bank may have expected from two consecutive 25bp movements.
This development may be a factor when the board meets on June 6. With a larger impact on loan rates than may have been expected, the decision may be to await the impact of the May move before moving again. As usual, predicting month to month moves by the bank is fraught with danger. It is better to assess the general sentiment of the bank and set a three to six month target. In that regard we confirm our call that there will be two more 25 bp moves, but recognise that the statement implies the risks are such that moves will be sooner than earlier expected.
The bank's inflation forecast and the general rhetoric in this SoMP leave the door open for rate cuts at any time. We had expected that the 50 bp cut would be in two tranches in August and November. This statement now indicates to us that these cuts can be expected earlier, by the end of the September quarter being concentrated in that July–September "window".
However, the evidence from this SoMP makes it quite clear that the case for another rate cut has already been made and every board meeting through the course of this year must be seen to be very much alive.
Bill Evans is Westpac’s chief economist.