Ground shifting beneath RBA forecasts

07 September 2011

Sometimes a forecast is superseded before it is released.  And the question for investors is whether that applies to the RBA's latest Statement on Monetary Policy (SMP).  Put simply, the message from the SMP is that things have got worse, but the RBA is sticking to the same tune about growth accelerating in 2012 and inflation edging above the target band.  Essentially, the risks around the global outlook have increased, but the Bank has not drastically changed their outlook at this stage.

It is important to remember that when the RBA began writing the SMP, financial markets were edgy, but not anywhere near as precarious as they are looking now.  Confidence was more resilient.  And the risk of a large European economy being drawn into the European sovereign debt crisis was still a risk, rather than a reality.

Some might argue that the recent performance of financial markets simply reflects skittishness, and that this shouldn't affect how the RBA views the outlook for the Australian economy.  But we suspect that the RBA's senior officers would have been busily rewriting the introduction to the Statement to try to keep pace with the rapidly changing outlook.

Given that, what can we glean from the SMP?   In our view, the most important question is what the SMP reveals about the RBA's sensitivity to financial market weakness.  Clearly, if the RBA didn't think that was a major threat to Australian growth, then there is little risk that the RBA will alter its rosy forecasts for growth in the medium-term and the RBA's traditional tightening bias will remain in place.

If, however, the RBA indicated that it was watching developments in Europe closely, then it would be justified to conclude that the growth forecasts printed in the SMP have already been consigned to the rubbish bin.  In this scenario, not only would a rate hike be off the table, but the chance a rate cut would become much more likely.

The chance of a rate cut might sound preposterous to those who have absorbed the RBA's constant fretting about the inflation outlook and its confidence in the mining investment story.  (Of course, a rate cut would seem to be completely obvious to financial markets which have aggressive rate cuts already priced in).

But recall that the RBA did undertake a precautionary rate cut in 1998 when the Asian crisis intensified and Russia defaulted on its debt. And that was despite strong growth in the Australian economy at the time (the RBA's forecasts for growth were also strong).  Similarly in 2008, the RBA was one of the first central banks to cut rates.  Thus, history demonstrates that the RBA can change direction quickly.  Moreover, they tend to act, before their rhetoric changes.

So with that in mind, what did the SMP reveal? 

Well, they state bluntly that this is a key downside risk.  Moreover, they considered the downside risk to the forecasts to have increased further due to weakening global economic data and the significant concerns around public finances in the US and Europe.  In particular, the Bank noted the adverse impact that these concerns have had on financial markets and the risk of it flowing on to economic activity. According to the Statement, it now "seems easier to envisage significantly worse outcomes for global growth than it is for significantly stronger outcomes".  This is a notable shift in perception for the RBA and suggests that there will be greater caution with regards to making monetary policy decisions.

So, how has the RBA’s outlook changed?

A much weaker than expected start to the year has mechanically generated a downgrade to the Reserve Bank's 2011 GDP growth forecasts.  GDP growth has been pared back from 4.25 per cent to 3.25 per cent, but more importantly, the RBA still sees GDP growth heading to 3.75 per cent over 2012 (unchanged from its previous Statement).

While this appears to be a strong forecast, we would argue that this actually reflects a slight downgrade to the Bank's growth expectations for two key reasons.  First, while GDP growth for 2012 is unchanged, it is coming off a base (i.e. 2011) that is 1 percentage point weaker than previously envisaged.  That is, growth is being lost in the current year, but not recovered in 2012.  This means that the level of output is now expected to be weaker in 2012 than previously expected.

The second reason concerns the Reserve Bank's underlying assumptions behind the forecasts.  That is, while the forecasts three months ago were framed by the expectation of a further 50bps increase in the cash rate, these latest numbers assume no change in the cash rate over the forecast horizon.  Basically, the RBA is assuming that interest rates will be 50bps lower next year, but growth will be much the same.  This is an indication of the weaker domestic demand conditions.

The inflation forecasts were pushed slightly higher over the forecast projections, but this mostly reflects the impact of the carbon tax coming into effect from mid-2012.  If this is excluded, inflation is expected to be 3 per cent over 2012, but is still seen edging up above the target in 2013.

In terms of risks to the forecasts, the major concern is the aforementioned risk to the global picture, which is now heavily skewed to the downside.  Domestically, the Bank sees risks as more balanced, with the major downside coming from uncertainty over the pace of expansion in mining investment, which is still assumed to be the main driver of stronger growth.

On balance, it looks as though the RBA is putting on a brave face, but increasingly appears to be on the back-foot in attempting to defend its strong growth forecasts.  As we have noted, the stronger growth expectations for 2012 are not a true reflection of sharply accelerating domestic demand and the risks to the global economy suggest that their global growth assumptions are too high.