RBA SOMP: Inflation forecasts lowered - Westpac

Bill Evans, Research Analyst at Westpac, notes that Reserve Bank of Australia has lowered its inflation forecasts in its Statement on Monetary Policy for November 2017 and according to Westpac, this Signals it now expects a much longer Period of Steady Rates.

Key Quotes

“The Reserve Bank has just released its November Statement on Monetary policy.”

“We have been surprised by some of the forecast changes in the statement. These forecasts are critically important because they summarise the Bank’s view on the growth and inflation outlook.”

“In the August Statement on Monetary Policy, GDP growth was forecast at 2-3% in 2017, 2 ¾-3 ¾% in 2018, and 3-4% in 2019. These forecasts are largely unchanged for the November revisions. Growth is still forecast at 2 ½ per cent in 2017, 3 ¼% in 2018, and 3 ¼% in 2019 (down slightly on the August forecast of 3-4%). The forecast unemployment rate from the August statement was 5-6% for 2017, 2018 and 2019. In this statement, the forecast is 5 ½% in 2017; 5 ½% in 2018, 5 ¼% in 2019. This slight reduction in the unemployment forecast for 2019 is more consistent with the above trend growth forecast for 2018 and 2019 than we saw in August.”

“The big change comes with the policy sensitive inflation outlook. Underlying inflation is now forecast at 1 ¾% for 2017; 1 ¾% for 2018, and 2% for 2019. These changes should not be entirely attributed to the revised weights in the CPI as released by the Australian Bureau of Statistics on November 6^th.”

“These changes are much more significant than that from a policy perspective.”

“The Bank is now telling us that over the whole course of 2018, inflation will remain below the bottom of its 2-3% target zone, and in 2019, it will only reach 2%, the bottom of the target range. This is a significant departure from the forecasts in August. The August forecasts had underlying inflation at 1 ½-2 ½% in 2017; 1 ½-2 ½% in 2018 and 2-3% in 2019. That is, the outlook for  2019 was that, underlying inflation would be back in the middle of the target band.”

“It would be inappropriate to merely attribute these changes  to a mechanistic adjustment. Bear in mind that the Bank has discussed the prospect of these weight changes in previous speeches and statements and had noted that previous adjustments took around 0.2% off the measured level of yearly underlying inflation. It is reasonable to asssume that with the knowledge that the re-basing was imminent, such an adjustment would have been taken into account, informally, in previous forecasts.”

“It is our view that the decision to lower the forecasts to below the bottom of the band in 2018 and at the bottom of the band in 2019 has significant policy implications. We are now assessing a central bank which is expecting that it will undershoot its core inflation target for another year, and that even one year out, inflation will still be at the bottom of the target zone.”

“It has always been our view that with the confident growth forecasts of ½ a per cent above potential growth in 2018 and ¾ above potential in 2019, and  inflation moving back to the middle of the target zone in 2019, that the Bank expected to be raising rates in 2018.”

“These new forecasts cast considerable doubt on that view.”

“We are not changing our view that rates will remain on hold in 2018 and 2019, but we have always been uncomfortable that the central bank’s forecasts were implying that it was expecting that it would be raising rates in 2018. These forecasts no longer portray a central bank that expects to raise rates.”

“The growth outlook

The bank provides a useful analysis of the risks around the growth outlook. Recall that it has retained its 3 ¼% growth forecast in 2018, and has slightly lowered its 2019 forecast. Some key observations around their views are:

1. They have become more confident around the non-mining business investment outlook, particularly referring to some recent upward revisions which point to stronger momentum in that regard. However, they continue to link faster growth in investment to businesses’ assessment of rising household consumption.
2. The core forecast expects that consumption will “pick up a little”, along with “a gradual increase in wage growth”, however they are decidely uncertain about both prospects. While they note that some industries are having difficulty attracting labour, they also  point out that wage growth in newly negotiated enterprise agreements has declined. The Bank also has revised down its forecast for the revovery in average earnings which have even undershot the admittedly weak wage price index, probably reflecting a rebalancing in the jobs mix to  low paid jobs.
3. The expectation for rising wages growth is clearly dependent on ongoing strength in jobs growth and a fall in the unemployment rate  reducing spare capacity in the labour market  although the ongoing rise in the participation rate represents a risk. On the other hand, there is this uncertainty about structural factors, including technology and globalisation, which may be restraining wages growth given benign wages growth in many countries which have even tighter labour markets.
4. The Bank also recognises  other factors that may constrain incomes and spending particularly high household indebtedness and changes in wealth. With house prices now losing momentum particularly in Sydney, perceptions of rising wealth may constrain spending.
5. The Bank has also lowered its outlook for dwelling investment  now expecting it to peak earlier than previously anticipated. However, it still assesses that dwelling investment will have a neutral effect over the forecast period.”

“Our lower growth forecasts for next year at 2.5% are predicated on weaker household consumption than the Bank implies; a sharper downturn in residential investment and a more modest uplift in non-mining business investment. All these issues are interconnected with weaker signals from the household sector likely to weigh on business confidence and employment decisions while a sharper dowturn in housing construction will generate spare capacity in the building sectors and ease jobs growth.”

“Conclusion

• This is a significant set of forecast revisions and we believe signals a changed policy outlook from the Bank itself. While the Governor will continue to indicate that the next move in rates will be up, we think that the rhetoric around a long period of steady rates will gain further emphasis.
• Forecasting another year of inflation undershooting the target zone might, in other circumstances signal a central bank which is contemplaying further rate cuts. However, it still believes that growth will lift to above trend, and the experience of 2016, when two rate cuts triggered another surge in house prices will temper any inclination to cut again.”