Weekend Economist: Turning point?

Policy makers and markets must decide whether recent tentative signs of moderation represent a turning point the economic cycle, or another mid-cycle pause.

Business and consumer sentiment weakened significantly in March and April, which has reinforced the market’s view that the RBA has now completed its tightening cycle, with an expected easing in monetary policy still almost fully priced for later this year. The April Westpac-Melbourne Institute consumer sentiment index fell 1.3 per cent month-on-month 87.4, the lowest level since June 1993. It was the fourth consecutive month-on-month decline and leaves the index down 24.2 per cent year-on-year. The survey is consistent with a recent moderation in retail sales reported for January and February and which likely extended into March, setting the stage for subdued first quarter consumption growth.

The consumer sentiment index is normalised to 100, so sentiment has been below average for the last three months. But given the news flow over recent months, it would be surprising if consumers could maintain above
average levels of confidence. The media gives saturation coverage to changes in interest rates (there were 550 related stories listed on Google News on the day after of the RBA’s March tightening) and report every interest rate rise as though it were the end of the world. At the same time, media reports have conveyed a false impression of widespread mortgage stress. Together with a heavy flow of negative overseas financial and economic news, sentiment was bound to suffer, but it is unlikely that this sentiment is a reflection of actual economic conditions. The family finances component of the survey actually improved in April, suggesting that the downturn in sentiment is largely a reflection of overwrought media reporting in relation to the economy more generally.

Once again, little attention was paid to that other survey of consumers, measuring their 12-month inflation expectations. The April survey saw a moderation to 4.3 per cent from 4.6 per cent in March. Inflation expectations have held above 4 per cent for seven months, consistent with the likely first quarter CPI outcome. The percentage of consumers expecting inflation to remain in the 2-3 per cent range over the next year fell once again, to 11.2 per cent compared to 11.8 per cent in March. If consumers share the market’s expectation that the official cash rate with ease to 6.86 per cent by April next year, then the expected real official interest rate at a one-year horizon is only 2.56 per cent, well below the RBA’s assumed neutral real rate of 3 per cent.

The combination of elevated actual and expected inflation, together with market expectations for an easing in nominal official interest rates implies that the effective stance of monetary policy has already been eased somewhat, although increases in some market-determined lending rates provide an offset to this. The three-year and 10-year bond futures spread disinverted briefly in March, despite a tightening in policy. The steepening in the yield curve provides further evidence of an easing in the effective stance of monetary policy, despite increases in nominal official interest rates.

A recurring pattern through the current tightening episode has been for the RBA to foreshadow a moderation in domestic demand and inflation, with the market then buying into this view, weakening the transmission of the RBA’s policy stance out along the yield curve. This in turn makes it less likely that the forecast moderation in demand and inflation will actually be realised. The failure of the RBA to appropriately condition market expectations through the tightening episode of the last few years has arguably undermined its policy stance, requiring a larger increase in the actual official cash rate to compensate for the failure to sustain expected real interest rates at higher levels.

The key question for policy makers and markets is whether the recent very tentative signs of moderation in domestic demand represent an emerging turning point in the economic cycle, or just another mid-cycle pause.
This week’s data could be consistent with both interpretations. Less ambiguous, however, was the large boost to the terms of trade implied by recent contract price negotiations for coal and iron ore, which have been challenging the RBA’s forecasting assumptions in relation to growth the terms of trade.

Asian steelmakers agreed to contract coal price increases of between 200-300 per cent this week, a reflection of the shortages in the spot market due to weather-related supply disruptions in Australia and China. This is
the positive side of Australia’s record trade deficit in February, which was largely driven by adverse weather events weighing on export volumes. While many analysts have bemoaned the weakness in export volumes and
the widening in the trade deficit, this is not unrelated to the higher export prices that will see a substantial positive impulse to real national income from the second quarter onwards. Next week, the first quarter merchandise terms of trade is expected to rise 0.7 per cent year-on-year compared to 1 per cent year-on-year decline in the fourth quarter of last year, even before the increases in bulk commodity contract prices begin to flow through from April. The trade and current account deficit is an unambiguous sign of economic strength, not weakness.

There is a risk that the gains in national income from renewed growth in the terms of trade will see consumers and business shrug-off recent increases in nominal official and market-determined interest rates, giving a renewed impulse to domestic demand. In that event, the RBA will be struggling to contain inflation from a starting point that is already well above the upper bound of the 2-3 per cent target range.

Next week, February housing finance is forecast to decline 1.4 per cent month-on-month, pointing to further weakness in building approvals and upward pressure on rents and inflation from acute shortages in dwelling stock. March quarter export prices are seen rising 3.4 per cent quarter-on-quarter, while import prices are seen declining 0.1 per cent quarter-on-quarter, highlighting the renewed strength in the terms of trade. The RBA releases the minutes of its April Board meeting on Tuesday, which may see some further elaboration on the rationale for the RBA’s steady policy stance at that meeting, after two consecutive rate rises in February and March.

Dr Stephen Kirchner is an independent financial market economist. His blog can be found at http://www.institutional-economics.com.

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