Weekend Economist: Steady as she goes

The Reserve Bank will now be mulling over its forecasts for the November statement on monetary policy (SOMP) which will be released on November 7.

Despite some significant changes in markets and likely the underlying forecasts for the Australian dollar and commodity prices we do not expect them to change their core views.

These are that growth will be well below trend in the second half of 2014; remain below trend in 2015; and only lift to above 
trend in 2016. Equally they will maintain their inflation forecast that underlying inflation will be in the top half of the target range 
in 2015 although we think it will be necessary to “tweak” the underlying inflation forecast higher in 2014.

A key factor for the November SOMP forecasts will be the change in the exchange rate since the last statement in August. In that 
statement the assumptions used for the Australian dollar were trade-weighted index (TWI) at 72 and Australian dollar at $US0.93.

It is likely that the assumptions for November will be TWI at 68 and Australian dollar at $US0.87 – an effective devaluation of around 5.5 per cent since the August SOMP.

The fall in the Australian dollar will impact forecast considerations. Consider the discussion on growth in the May statement where the Australian dollar had risen from TWI 69 and $US0.89 in February to TWI 71 and $US0.93 in May.

In May the commentary was “the rise in the exchange rate over recent months – which is expected, at the margin, to restrain 
exports and boost imports over the next two years". The growth forecasts were little changed from February due to an offsetting 
“slightly stronger outlook for consumption and dwelling investment over the coming year”.

The expected revisions to the exchange rate in November are likely to boost the forecast outlook for net exports but there is likely to be an offsetting adjustment on domestic demand to keep the forecasts largely unchanged.

Downward adjustments are likely to come from:

1. A downward adjustment to the estimate of gross national income in light of the further falls in the terms of trade that would have not been expected at the time of the August meeting (“iron ore and coal prices are forecast to remain close to their current levels”). Since that meeting Westpac's bulk commodity index has fallen by a further 10 per cent.
2. The forecasts were based on Brent oil remaining at $US106 per barrel. The current market price for Brent is around $US80. That sharp fall will have two offsetting effects on the growth outlook – some assumed lift in disposable income with lower petrol prices but a downward adjustment to expected LNG prices and the terms of trade from 2015 when gas supplies start to flow.
3. Consumer sentiment has disappointed since the August SOMP. A “timely measure of consumer sentiment has rebounded more recently” – that comment referred to the jump in sentiment in a volatile weekly series which indicated that sentiment had lifted by around 16 per cent from post budget levels – that read was clearly the sort of overstatement you expect from weekly data but was partly reflected in the Westpac MI index which jumped by 3.8 per cent in August to be 6 per cent above its post budget level. However, the Westpac MI index has subsequently fallen back to be only 2 per cent above its post budget level. 

Recent statements from the RBA seem to confirm that it is likely to maintain its downbeat forecasts in the November SOMP. For 
example, the October board minutes noted that the June quarter showed “moderate growth” and the RBA expects moderate growth in the September quarter. In particular, its liaison and recent retail sales data suggested moderate growth of consumption had continued into the September quarter. However, that is not likely to lead to a downgrade of forecasts given that in August it was already being described as “consumption growth is anticipated to pick up to a slightly above trend pace... (not until) 2016”.

With no change likely in the growth forecasts (in fact the risks, if anything, are to the downside, despite the fall in the Australian dollar) will the lower local currency and the September quarter inflation report prompt a revision to the inflation outlook?

Recall that in August the RBA forecast underlying inflation to print 2.25 per cent in the year to December 2014. For the first two quarters of 2014 underlying inflation had printed 1.25 per cent. That meant that the RBA was expecting 1 per cent for the last two quarters. The September 2014 print was 0.5 per cent so the issue is whether it is expecting another 0.5 per cent for the December quarter. We believe there is a risk that the RBA will have to revise up its forecast for underlying inflation in 2014 from 2.25 per cent to 2.50 per cent.

Despite a very low (0.3 per cent) read for headline inflation in December quarter due mainly to lower petrol prices (reflecting the big fall in the oil price) underlying pressures are expected to lift from the September quarter partly due to seasonal factors. If the RBA also expects that profile it might mean that the original forecast of 1 per cent for underlying inflation in the second half of 2014 implied a 0.4 per cent or 0.3 per cent forecast for underlying inflation in the September quarter due to an indirect carbon tax effect. Reverting back to a “normal” quarterly read on the December underlying print (especially given the recent fall in the Australian dollar and the indirect effects of the fall in the oil price) is likely to push the RBA to revise up its near term forecast for underlying inflation to a (still non-threatening) 2.5 per cent from 2.25 per cent. That 2.5 per cent is closer to our own view of 2.4 per cent than the RBA's current forecast of 2.25 per cent.

The lower Australian dollar and the fall in the oil price are likely to see the RBA stick with its call of 2.75 per cent for underlying inflation in 2015. That forecast does match our own forecast for underlying inflation in 2015 of 2.8 per cent.

This mix of forecast changes (or lack thereof) is hardly likely to be of concern for markets. It will also sustain a considerable difference in forecasts between Westpac and the RBA. We expect growth in 2014 of 3.2 per cent with 3.2 per cent in 2015 – that implies growth around trend.

If, as we expect, the RBA produces another set of clearly below trend forecasts for 2014 and 2015 we can fairly question why it has not cut rates again.

Bill Evans is a chief economist at Westpac.