The Reserve Bank has released its August Statement on Monetary Policy.
As foreshadowed in the Governor’s Statement following the August Board meeting the Bank has lowered its growth forecasts and substantially lifted its inflation forecasts since the May Statement on Monetary Policy.
Note that the forecast period has been extended from June 2024 to December 2024.
GDP growth has been lowered in each of the forecast years, 2022: 3.2% (4.2% in May); 2023: 1.8% (2.0% in May); 2024: 1.7% (from 2.0% in May to June 2024).
Headline Inflation has been lifted: 2022: 7.8% (5.9% in May); 2023: 4.3% (3.1% in May); 2024: 3.0% (from 2.9% in May to June 2024)
Trimmed Mean Inflation has been lifted: 6.0% (from 4.6% in May); 3.8% (from 3.1% in May); 3.0% (from 2.9% in May to June 2024).
Unemployment Rate: 2022: 3.4% (from 3.7% in May); 2023: 3.5% (from 3.6% in May); 4.0% (from 3.6% in May).
The forecasts are based on a Trade Weighted Index for the AUD at 63, the same as in May although against the USD there has been a cut from USD0.71 to USD0.69.
The oil price (Brent) is forecast to hold at USD 94bbl ($101bbl in May) and hold there over the forecast period. That assumption does put some upward bias into the inflation forecasts given that most inflation forecasts assume a lower oil price over the forecast period.
But the assumptions around the cash rate are significantly different. In May the Bank used a profile of the cash rate reaching 1.75% by December 2022 and 2.5% by December 2023.
The forecasts in August are based on the cash rate reaching around 3% by December 2022 and “declining a little” by December 2024.
Use of a higher cash rate profile might explain the downgrade in the growth forecasts in 2023 and 2024 but these downgrades are quite minimal (1.8% from 2.0%).
But of most interest is the acceptance that, unlike in May, headline inflation stays well above the top of the target band in 2023, and only just makes it in 2024.
Contrast these forecasts with Westpac’s forecasts that assume the cash rate reaches 3.1% by end 2022 and peaks at 3.35% by February 2023. As with the Bank we think the rate will hold throughout 2023 at this higher level but can be cut by 100 basis points in 2024.
That higher rate profile causes growth in 2023 to slow more sharply to 1% from 4.4% in 2022 compared to the Bank’s profile of 3.2% to 1.8% (a more gentle slowdown than expected in May – 4.2% to 2.0%) despite a higher expected rate profile.
In our profile the unemployment rate is expected to lift from 3% to 5% over 2023 and 2024 compared to the Bank’s forecast of 3.4% to 4.0% over the two year period.
But our much weaker growth profile in 2023 allows the prospect of inflation falling back to near 3% in 2023 – indicating that the Bank would have succeeded in its inflation objective albeit at a greater cost to economic growth in the short term.
It also allows for the prospect of rate cuts in 2024, whereas the Bank’s forecast of 4.3% inflation by end 2023 precludes that prospect.
The key reason why we insist that a sharper slow down in demand is required in 2023 is that a much stronger set of demand conditions (we forecast consumer spending growth of 1.2% in 2023 compared to the Bank’s 2.4%) runs the risk of resilient high inflationary expectations.
The Statement refers on a number of occasions to the risks around inflation expectations: “one uncertainty affecting the outlook for inflation is the possibility that inflation expectations and general inflation psychology shift, and lead to the higher inflation being more persistent.” (Overview).
The RBA assess that: “medium-term inflation expectations remain well anchored”.
However, we think there has already been a significant shift. The section in the SOMP on inflationary expectations shows that trade unions’ expectations for the 5 to 10 year period have lifted from 2-2.5% to 3.5% while unions’ one year expectations have lifted from less than 2% to 6%.
But it is also firms’ expectations that count in this cycle. If firms believe that they have ample scope to raise prices they will do so and be more flexible with wage demands. The SOMP refers on a number of occasions to firms acknowledging more scope to raise prices.
A key determinant of that assessment will be firms’ assessments of the state of demand and the preparedness of the central bank to use policy to slow that demand.
A forecast of 1.8% growth and 4.3% headline inflation in 2023 looks to be risking firms being emboldened to continue raising prices with demand conditions solid and the central bank prepared to be very patient in its inflation objective - apparently favouring the prospect of keeping the economy on an “even keel” rather than addressing the paramount need to bring inflationary expectations back into line.
We would like to have seen inflation and growth forecasts more consistent with a central bank that is determined to reach its inflation objectives over a shorter time period than 2½ years.
Our peak rate forecast of 3.35% is higher than the forecast of 3% used in the Bank’s forecasts. We believe a 3% cash rate would have a more debilitating impact on the economy than the Bank is forecasting but not sufficient to achieve the 3% inflation target by end 2023.
That target/forecast of 3% inflation by end 2023 should be adopted by the Bank and if a significantly higher terminal cash rate would, in their view, be required to reach that goal then they should use that rate in the forecasts. That does not mean that the rate needs to be rapidly pushed through the assessed “neutral” and into the contractionary setting, but it may mean that the Bank expects it to take more time to reach its higher peak.
It does not “feel” right that the Bank should be taking the cash rate forecast from the market / analysts and forecasting a mild slowdown and the need for 2½ years to reach even the top of the target band.
It would be much more satisfactory to see a set of forecasts that indicated a much weaker demand climate in 2023 and a significantly more rapid achievement of the inflation target.
From our perspective we believe that outcome would be achieved with a terminal rate of 3.35%, 35 basis points higher than the rate used in the RBA forecasts.
Arguably, the Bank believes a much higher rate would be required to achieve the objective. If so, we would have liked to have seen that rate used in the forecasts with the forecasts signalling the intention to get back to the top of the band by 2023.
Such an approach would give the Bank the best chance of managing this difficult task of returning inflationary expectations to more normal levels and deflating the current “inflationary psychology” which is now at risk of taking hold.
©2022 Westpac Institutional Bank is a division of Westpac Banking Corporation (‘Westpac’) ABN 33 007 457 141 AFSL and Australian credit licence 233714.
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