Weekend Economist: The wedge widens

The Reserve Bank board meets next week on December 3. It is almost certain that the Board will decide to hold rates steady.

That is despite the recently revised forecast in the November Statement on Monetary Policy that growth in the Australian economy would be below trend at 2.5 per cent in 2014. Momentum in the economy is broadly forecast to remain flat at 2.5 per cent throughout the year with a pick-up to 3.5 per cent expected in 2015. Of course, there is also no inflation constraint around policy, with core inflation forecast at 2.25 per cent in 2013 and 2.5 per cent in 2014.

Presumably the justification behind the decision to stay on hold is around the expectation that growth will be well above trend in 2015. However, given the wide confidence ranges around growth forecasts, it seems to be more prudent to develop policy around the 1-year rather than 2-year forecasts, around which there must be considerably greater uncertainty. That uncertainty is evident in the wide forecast band for 2015, which is 2.75 per cent to 4.25 per cent.

Indeed, the Bank does appear to have decided that more stimulus is required for the Australian economy – but not through interest rates. That stimulus is now being sought through the unconventional channel of 'talking down' the currency.

Hence it is likely that the Governor's Statement following the board meeting will remain subdued and retain the wording: "it was prudent to hold the cash rate steady... but not to close off the possibility of reducing it further".

At a public dinner on November 21, the governor also seriously raised the possibility of intervening in the currency market.

The approach has been mildly successful with the Australian dollar falling from US92.5¢ to US91¢ over the last week.

Doubtless the board will be encouraged by this initial 'success' and will continue to pursue this policy over the next few months. However, in the speech at the public dinner, he did not offer any views on the extent of overvaluation of the Australian dollar. In the past, the Reserve Bank has noted that a similar fall to the May– June US10¢ depreciation would be helpful to rebalance the Australian economy.

It is my view that such a fall is unlikely, given our expectation that US tapering is much further off than suggested by the current market and the Reserve Bank.

On the question of whether the Australian economy does need more stimulus, we were keen to dissect the third quarter private capital expenditure survey released yesterday. The survey is the first test of whether the promising boost to confidence we have seen in business surveys is being reflected in business investment and providing some encouragement that it will also see a boost to employment.

Below I summarise our take on the current dynamics of the Australian economy.

Since the onset of the global financial crisis, consumer sentiment has been volatile. But in recent months it has settled around pre-GFC levels. It also shows that a disturbing wedge has opened up between overall sentiment and how respondents assess their job security, as proxied by their expectations for unemployment.

Broadly speaking, consumers' unemployment expectations stand around 20 per cent below pre-GFC levels. That is also true of surveyed business conditions, highlighting another wedge that has opened up between consumer confidence and business conditions. The dynamic that appears to be operating here is a tentative approach by business that is manifesting in poor jobs growth and impacting the security assessments of households. While households remain insecure around job prospects, spending will be subdued.

The Capex survey was a good test as to whether business is coming out of its torpor with a potentially more positive attitude towards spending and hiring. Hopes were high given the boost to confidence since the election.

This survey included the fourth estimate of investment intentions for 2013/14. The interest is around how this estimate compares with the third estimate that was printed in August. That earlier survey was conducted in late July/early August when the government was experiencing a recovery in the polls (due to a leadership change) and the Budget was announced to have an additional $40 billion 'hole' due to the deteriorating terms of trade. It was a clear low-point for business confidence. As such, the November survey was expected to show a marked improvement to at least become comparable with the May survey.

There are many ways to assess this survey. We prefer to use a conservative approach, which takes the 10-year average realisation ratio for manufacturing and services and the three-year average for mining. A realisation ratio is required to 'mark-up' Capex plans, as historically these have shown systematic divergences with actual.

On that figuring, mining investment plans improved from an estimated fall of 6 per cent in August to 4 per cent in November; manufacturing plans showed a 12 per cent fall in August compared to a 10 per cent fall in November; and service sector plans showed a 4 per cent rise in November compared to a flat outlook in August. Overall, the November survey pointed to a 1.6 per cent fall in investment in 2013/14 compared to a 4.2 per cent fall in August.

We saw a modest improvement in November, with the key result being a move from flat to a 4 per cent rise in the services sector. However, given the extreme circumstances of the August survey, I would argue that the improvement is fairly modest.

For instance, the November results are significantly weaker than the results in May when mining was expected to expand by 7.6 per cent; manufacturing to contract by 'only' 4.2 per cent; and services, which is the key to rebalancing the investment spend, was planning to increase Capex by 11 per cent.

Overall, this survey is disappointing and consistent with our concern that business is not responding to the potentially uplifting news around the change of government.

Further stimulus will be needed for the Australian economy. For now the Reserve Bank appears content to address that through the currency. However, given the heavy reliance on offshore developments and the uncertainties around actually adopting an intervention policy, we expect that, in due course, the Bank will have to revert to the more conventional interest rate approach.

Bill Evans is Westpac's chief economist.