WEEKEND ECONOMIST: The growth question
Consumer sentiment is high, yet consumers remain cautious about spending. Housing finance is falling, yet house prices are soaring. No wonder the RBA is hesitant about raising its growth forecasts.
The minutes of the April meeting confirm to us that the surge in coal and iron ore prices over the previous two months motivated the Board to bring forward the timing of their actions to restore interest rates to "more normal levels". That was the first set of minutes where the policy adjustment process is not described as "gradual" and therefore does not preclude the possibility that we can expect another move of 25 basis points in May.
In the Toowoomba speech the Governor moved further from the "gradual" concept by comparing the pace of the rate hikes with the pace of the preceding rate cut cycle, "Hence the cash rate has risen by 125 basis points over seven months – which is still only about a third the pace of the earlier declines."
The rationale behind restoring rates to normal levels, but not necessarily above those levels, is in the forecast which the Bank currently has for domestic growth to be "in 2010 ... around trend" – an implied increase in the Bank's growth forecast from the February Statement on Monetary Policy.
Governor Stevens spells this out even more clearly in the speech: "If the economy is growing close to trend, and inflation is close to target, one would expect rates to be pretty close to average".
With almost half the year already gone it seems likely that the policy to restore rates to normal levels needs to happen sooner rather than later. Certainly we expect that the next move, which we assess will restore rates to average, is likely as soon as May, or June at the latest.
Our long held view that "average" is seen as an overnight cash rate of 4.50 per cent (only 25 basis points from current levels) is given some support by the minutes. Rates before this move were described as "still a little below average". After the April move, surely an additional 25 basis points could be interpreted as having restored rates to "average". The speech used a bit of the Australian vernacular but a similar implication, "rates are now pretty close to that average".
What we don't know from the minutes or the speech is whether the Bank has raised its growth forecast for 2011 to above-trend. In those circumstances, rates are likely to need to be pushed above average through the course of 2010. The reason why the Bank is rightly hesitant about that forecast is that there are some puzzling aspects to the current data flow. The Bank points out that despite consumer sentiment at a "high level", consumers are "quite cautious" with "little growth in retail spending over recent months". It notes the falls in housing loan approvals which seem "somewhat at odds" with the current house price growth.
It notes "some caution in spending plans for businesses outside the mining sector" and the non-residential building sector remaining subdued. The recovery in the global economy was still described as "two-speed"; and while we are not given any more information in these minutes, we expect that the Bank remains cautious about the sustainability of the recovery in US, Europe and Japan.
The speech is clearer on this issue noting that the outlook for demand seems likely to be driven more by investment, both private and public, and less by consumption than in some previous periods.
A critical issue for us will be the Bank's new growth forecasts. These will be released in the Statement on Monetary Policy on 7 May – three days after the May Board meeting and four days before the Budget. In noting in the minutes that the Bank's last (February SOMP) forecast of the terms of trade has been increased significantly and implying it has raised its growth forecast for 2010 to trend we can assume that the February forecast of 3.25 per cent growth in 2010 will be raised to 3.5 per cent which we believe the Bank assesses as "trend."
Reflecting the increase in the terms of trade we have also revisited our own growth forecasts. We have not changed our forecast of growth through 2010 – keeping it at 3.5 per cent since we have a slower build up in the terms of trade than the Bank. The speech indicated that the terms of trade would exceed 2008 levels in 2010. We do not see that occurring until the first half of 2011.
We have, however, raised our forecast of growth through 2011 to 3.75 per cent from 3.5 per cent. That largely reflects somewhat faster income growth due to the terms of trade boost. However, we are not expecting to see consumer spending growth exceed that of disposable income as is usually the case when recoveries build. The typical action of consumers to run down savings and draw down equity to finance spending growth at a faster pace than incomes is unlikely to figure in this recovery cycle.
Consistent with the theme of the speech our growth forecasts for 2011 assume 20 per cent growth in infrastructure investment (mainly mining related) and 10 per cent growth in plant and equipment investment.
If as we expect, the Bank on May 7 adopts similar growth forecasts to our own there will be ample justification for moving rates to "average" at the May 4 board meeting. Why hold rates below "normal" when you have raised your growth forecast to trend?
The argument for pushing rates into the contractionary zone on the basis of a growth forecast that is only slightly above trend for 2011 is not strong. Further evidence over the course of 2010 would be needed to justify that move at least to believe that growth risks are to the upside. Short of a further substantial upgrade in the terms of trade, evidence that the household sector is moving back to its "old ways" of running down savings and drawing down housing equity would be needed.
With consumers currently concerned about their own financial position (sentiment down by 8 per cent in the last Consumer Sentiment survey) and twice as many households seeing "pay down debt" as the wisest place for savings than normal that prospect looks low, at least for now.
In short, the undeniable boost being given to the economy from the resources boom may be coming at a cost which will make policy particularly difficult once rates are restored to normal levels. Our view is that the Bank will take a decent pause to assess these conflicting forces before it sees the need to move policy into the specifically contractionary zone. However, a swift move to get back to normal levels seems almost certain.
Bill Evans is chief economist at Westpac.