WEEKEND ECONOMIST: Severe weather alert

The national accounts, to be released on Wednesday June, will estimate activity conditions at the start of 2011. The statistician's task is more difficult than usual, with severe weather events significantly disrupting normal operating conditions.

Our forecast for Q1 GDP growth is -1.0 per cent (quarter), 1.1 per cent (year), with output dented by these temporary disruptions. In turn, a return to more normal conditions will inflate growth rates in coming quarters, complicating assessment of the underlying growth trend.

Net exports and inventories are forecast to slice -1.7 percentage points off Q1 growth. Key coal and iron ore export shipments were hard hit by flooding and cyclones. Domestic demand is forecast to expand by a moderate 0.7 per cent (quarter). Pluses were: housing and business investment, but growth was constrained by subdued consumer spending and winding back of fiscal policy stimulus.

Beyond Q1 weather disruptions, we expect growth to be above trend at a time of world growth of 4.2 per cent in 2011 and in 2012. The CAPEX survey confirms a mining investment boom during 2011-12 in response to a once-in-a-century terms of trade high. Conditions outside of mining will be mixed. Rising incomes from the higher terms of trade, rapid growth in the Asian region and activity generated by the mining investment boom will all be pluses. However, there are a number of headwinds: rising interest rates, the high Australian dollar, stretched housing affordability, household debt and fiscal consolidation.

Domestic demand:
Domestic demand (0.7 per cent): Domestic demand growth is expected to strengthen from an insipid rise of 0.3 per cent in Q4. Quarterly partial data indicates a rebound in housing and infrastructure work.

Household consumption (0.5 per cent): Consumer spending growth most likely remained modest in Q1 (with some strength expected in services), following a 0.4 per cent rise in Q4. Keep in mind that annual population growth was 1.6 per cent during 2010 (down from 2.1 per cent a year earlier). Real retail sales were flat, following a decline of -0.4 per cent in Q4. Motor vehicle sales dipped a little, reversing the Q4 rise.

Dwelling construction (2.7 per cent): Quarterly data indicates that housing activity rebounded from small declines in Q3 and Q4. New residential building increased by 4.0 per cent, with strength in NSW and Victoria offsetting a drop in Queensland. Renovation work rose 0.9 per cent.

New business investment (1.6 per cent): Quarterly partial data points to a third consecutive rise in business investment. By industry, CAPEX reported a strong rise in services sector investment, up 5.4 per cent in Q1 to be up 15 per cent over the last three quarters. Mining-sector investment also made a contribution, up 2.8 per cent (quarter), surging 21 per cent over the year. Manufacturing remained volatile, down -4.2 per cent following a 5.4 per cent jump in Q4. By asset class, CAPEX reported equipment up 2.4 per cent, and Construction Work Done reported infrastructure up 3.6 per cent, more than offsetting weaker non-residential building activity, down -3.0 per cent.

Public demand: unwinding fiscal stimulus
Public spending (0.4): We anticipate a fourth consecutive modest rise in public demand, with growth limited by the unwinding of fiscal stimulus. Public investment is forecast to fall by -2.2 per cent (quarter), -7 per cent (year), with quarterly data reporting public construction down -3.6 per cent (quarter), -3.8 per cent (year). Public consumption (representing 74 per cent of public demand) is expected to report another strong rise, in part boosted by efforts during the devastating January floods.

Net exports & non-farm inventories: major drag
Net exports (-1.5 percentage points): Net exports are set to make a large subtraction from Q1 growth as flooding and cyclones saw export volumes drop by a forecast 4.5 per cent, while import volumes continued to advance, up almost 2 per cent, to meet rising domestic demand.

Private non-farm inventories (0.2 per cent, -0.2 percentage point contribution): Production disruptions from flooding and cyclones most likely forced miners to further rundown already limited inventories as they attempted to meet export orders. We note that the forecast of –1.0 per cent for GDP growth in the March quarter is a large negative by historical standards. There have only been two quarters since the recession of the early 1990s when GDP has contracted in the quarter. The first was Q4 2000 (–0.4 per cent) and the second was Q4 2008 (–0.9 per cent). Both were very special periods for the Australian economy – the aftermath of the introduction of the GST, which caused a huge distortion in the growth pattern for the Australian economy with, in particular, housing activity being brought forward. The second was the low point of the GFC for Australia where domestic demand and global trade collapsed.

On both occasions the media speculated as to whether Australia was entering a recession (two consecutive negative quarters) and there was a marked downturn in consumer confidence, with the Westpac–Melbourne Institute Index falling by 13.2 per cent and 4.6 per cent respectively. We do not expect a similar response to next week's announcement. The media, official commentary and market economists have conditioned the consumer to link this contraction with the extraordinary impact of the floods and cyclones on exports, particularly coal and iron ore exports. We are expecting a contraction in export volumes of 4.5 per cent – there have only been six quarters over the last 30 years when exports have contracted by more than 4 per cent.

As normal production resumes in the mines and ports, and the rebuilding gathers pace, it is expected that growth will be boosted from the June quarter. For example, the Reserve Bank's latest forecasts imply growth in the second half of 2011 reaching an annualised pace of around 5.25 per cent, with the unemployment rate steadily falling to 4.25 per cent by end 2013.

In sharply raising the hawkish rhetoric in its latest board minutes and Statement on Monetary Policy to a level which is consistent with an immediate rate hike, the bank acknowledged that the economy was likely to contract in the March quarter. The significant signal on growth was raising its forecast for growth through the June quarter and beyond. We do not expect that a negative print on GDP would, of itself, dissuade the bank from moving on rates. Of course, news from the latest CAPEX survey that an upgrading of investment plans by the miners has pushed forecast investment growth to around 40 per cent in 2011-12 would have further strengthened the RBA's assessment of the threat which the mining/China/terms of trade/tight labour market nexus poses for inflation.

We have argued that this pre-emptive rate hike is likely to do sufficient damage to the housing/consumer sector of the economy to preclude another move until the June quarter next year. Waiting another month past June to move would be something which in the normal course of events would be insignificant for a central bank. However, the painful memories of watching core inflation soar to 4.7 per cent in the last mining boom, partly because the bank was slow to act, will be a constant weight on the minds of the board members.

Bill Evans is Westpac's chief economist.