RBA cuts inflation forecasts strongly: Westpac's Bill Evans
GUEST OBSERVER
The Reserve Bank has released its latest quarterly Statement on Monetary Policy (SoMP) for May.
While its growth and unemployment forecasts were left unchanged compared to February, the Banks’ inflation forecasts are more dovish than we had expected.
There is always considerable interest in the Bank’s SoMP forecasts as they offer the clearest guidance to its policy inclinations. That is even more the case this month given the May rate cut and the somewhat limited guidance in the Governor’s statement accompanying the move.
Note that an important consideration is how the Bank’s forecasts are framed by its assumptions on the exchange rate and interest rates. For May, these are for an AUD of USD 0.75 and 62.5 in TWI terms, and for ‘market pricing’ that has the cash rate falling 15bps by August and to 1.50% by February next year. That compares with forecasts in the February SoMP that assumed an AUD at USD 0.72 and 62.0 in TWI terms, and ‘market pricing’ that had a full rate cut (from 2% to 1.75%) by September. Noting that the RBA favours the TWI for its forecasting, the assumptions around the AUD will not have significantly affected the forecasts. However, the May forecasts are based on a cash rate that is 0.25% lower across the entire forecast period.
Growth forecasts
Recall that in the last SoMP, on February 4, the RBA had growth forecast to run at 3.0% in the year to December 2016; 3.0% for the year to December 2017; and 3.5% for the year to June 2018 (all figures are mid-points of 1ppt forecast ranges).
The May SoMP forecasts for growth are unchanged. This implies that if the Bank had not cut rates by 0.25% earlier this week then the growth rate for 2017 would have been revised down.
Inflation forecasts
In February the Bank forecast underlying inflation at 2.0 percent to June 2016; 2.5 percent to December 2016; and 2.5 percent to December 2017 (again all mid-points of 1ppt forecast ranges).
The Bank is now forecasting underlying inflation to come in at 1.5 perch t to June 2016 (implying a June quarter print of 0.5 percent qtr).
Beyond that it is forecasting inflation of 1-2 percent for the year to December 2016 and 1.5-2.5 percent for the year to December 2017 and the year to June 2018, i.e. a mid-point forecast of 1.5 percent for December 2016 lifting to 2 percent thereafter.
These forecasts are at the lower end of our expectations and can therefore be interpreted as clearly more dovish than we had expected.
They are saying that even after taking into account the latest rate cut and market pricing which anticipates a further cut by early 2017, underlying inflation is most likely to remain 0.5% below the bottom of the RBA’s 2-3 percent target band in 2016 and at the very bottom of the band in 2017, staying there even out to the end of the forecast period (June 2018).
Key to understanding the outlook for policy is the discussion on inflation
The downward revisions to the RBA’s inflation forecasts reflect a structural change in its view on domestic inflation and wages growth.
The reassessment is specifically attributed to: “the broad-based” nature of the weakness in non-tradables inflation and the fact that wage outcomes were lower than expected over 2015”.
On wages, the Bank notes that wages growth has been “much lower than the historical relationship with measures of spare capacity, such as the unemployment rate”. They suggest several factors may account for the divergence including: declining inflation expectations; the falling terms of trade; and a more flexible labour market. They also note that the phenomenon of “surprisingly low wage growth for given labour market conditions which has been apparent across a number of advanced economies” and particularly, the breakdown of the relationship between the unemployment rate and wages growth. They also, sensibly, observe the impact on wages of the movement of workers from highly paid mining related jobs to other employment.
Accordingly the Bank has revised down its outlook for wage growth: “will remain around current low levels for longer than previously forecast and pick up only very gradually over the forecast period”. More generally, unit labour costs are expected to be much slower to pick up than in previous cycles (historically, they have tended to pick up once the unemployment rate starts to decline).
Other factors seen as contributing to weak domestic cost pressures include: heightened retail competition (also affecting tradables, softer conditions in rental and housing construction markets and declines in the costs of business inputs such as fuel and utilities.
Also notable in the discussion of uncertainties around the forecast is the comment that “it is possible that inflation expectations will be persistently lower for longer than currently anticipated”. While that is placed alongside a range of other upside and downside risks, the risks around expectations are clearly skewed to the downside.
While clearly more downbeat on the outlook for non tradables inflation, the Bank has broadly retained its view that the gradual pass-through from the fall in the AUD since 2013 can be expected to add “a bit less than half a percentage point to underlying inflation over each year of the forecast period.”
This observation is ‘hedged’ a little with both the size and timing of the effect described as “inevitably imprecise”. The Bank also sees the impact being limited by heightened retail competition.
However, the discussion still implies that the bulk of the downward adjustment in the forecasts (from 2.5% to 1.5% in 2016 and from 2.5% to 2.0% in 2017) is due to the impact from lower non-tradable inflation.
Other points of interest
While the main message is clearly around the outlook for inflation and wages growth there were some other notable comments in the May SoMP.
On the global backdrop, the RBA has lowered its forecast for growth in Australia’s major trading partners “a little” with this now seen tracking 0.5% below its 10yr average. In particular, growth momentum was assessed as slower in Asia although within the region, expectations for China were unchanged since February, the soft March quarter outcome offset by a near term boost from policy measures. China remains a standout risk for Australia with the RBA voicing concerns that these recent stimulus measures appear to run counter to the Chinese authorities’ medium term goals of deleveraging and reducing dependence on investment and heavy industry and could see problems emerge if progress towards these medium term goals is delayed.
There is also an important sidenote on commodity prices. These have rallied strongly since the February SoMP. However, the Bank makes an explicit assumption that “prices for bulk commodities will not be sustained at current levels” with iron ore and coal prices after 2016 unchanged from the February SoMP. Oil prices are assumed to sustain at US$/47bbl but these have a mixed impact on Australia due to our high imports – the net effect is to leave the Bank’s terms of trade forecast largely unchanged compared to February. This is an important assumption as the rise over the last three months, if it had been assumed to continue, would likely have led to some (albeit minor) upward revisions to its growth and inflation forecasts.
Finally, there were some notable ‘absences’ in the SoMP overview. The closing paragraphs in the overview often take a similar form to those in the Governor’s decision statement and the ‘Considerations for policy’ section. Hence it can sometimes provide a bit more guidance around the Bank’s policy views, e.g. wording that sets out a clearer view on where the Bank would like the AUD to go or gives a framework implying a clear ‘policy bias’ going forward. Neither were offered in the May SoMP although the significance of the Banks’ forecast revisions is clearly the dominant policy ‘message’ this time around.
Conclusion
The changes to the forecasts for underlying inflation in this SoMP are, for a central bank like the RBA, nothing short of spectacular. This is particularly so given the new forecasts are based on a profile for interest rates that is 0.25% lower.
The revisions entirely support our expectation of a further rate cut in August. With inflation now driving the policy decision and rates so low, we would be surprised if the Bank chose to move any earlier.
For now, we think they will stick with a plan to re-assess the inflation outlook after the next inflation report (due July 27) and deliver a further rate cut at the Bank’s August meeting.
Updates on wage inflation (May 18), unit labour costs (with the Q1 national accounts release on June 1, a week prior to the RBA’s June meeting), and a wide range of inflation expectations measures will also be of keen interest.
On face value we have to ask ourselves whether the forecasts in the Statement, being based on the expected rate cut, are acceptable for an inflation targeting central bank.
Will the Board be comfortable with a forecast that inflation only rises to the bottom of the target range by the ‘policy year’? (i.e. 2017, the 12-18mth horizon over which current monetary policy settings and assumed near term adjustments are expected to have fully worked through to the wider economy).
We cannot entirely dismiss the prospect that reaching the bottom of the zone is unacceptable to the Board and, in due course, it will assess that even further action is required.
It will certainly be a challenging introduction for the new Governor when he takes over in September.
BILL EVANS is chief economist of Westpac.