Australian & New Zealand Weekly

Week beginning 19 May 2008

• Government's domestic demand forecasts will unnerve RBA.
• Westpac-MI Consumer Sentiment Index, a read on reaction to the Federal Budget.
• Central bank minutes in focus: RBA, Fed, BoE & BoJ.
• New Zealand Budget ahead of election 2008.
• Key economic & financial forecasts.

Australia: Gov'ts Domestic Demand Forecast Will Unnerve RBA

We were not surprised by the fiscal details of this weeks Budget. In our preview we predicted that the fiscal 'tightening' would be 0.3% of GDP and that the injection of new funds in 2008/09 would be around $5bn.

Readers will be aware that the Budget projects an increase in the fiscal surplus from 1.5% of GDP in 2007/08 to 1.8% of GDP in 2008/09.

The Budget expects a funds 'injection' of $7.1bn associated with the tax cuts, net expense savings of $7.3bn and new spending measures of $5.3bn - a net injection of funds of $5.1bn. That is an improvement on the previous three Budgets which averaged an injection of $9.7bn with around $12bn in last year's Election Budget.

We assess that the Reserve Bank wants to see demand grow by around $45bn less over the next year than in 2007 to allay its concerns about inflation. The government's action will help by adding $7bn less to demand this year than last year when the net injection of funds was around $12bn.

The aspect of the Budget that is most puzzling is the government's growth forecasts. It's always tricky to line the government growth forecasts up with those of the Reserve Bank.

Last Friday the Bank provided forecasts of inflation, GDP and non- farm GDP on a through the year basis for calendar years 2008 and 2009.

The government has provided forecasts (fully detailed breakdown) on a year average basis for 2007/08 and 2008/08 as well as a through the year forecast for 2008/09.

We expect that the Bank is basing its inflation forecasts (that underlying inflation will fall from 4% in the year to December 2008 to 2.75% in the year to December 2010) on its estimated slowdown in domestic demand growth in 2008 and 2009.

The difference between domestic demand growth and non-farm GDP growth is essentially the impact of the farm sector and net exports.

We estimate that the Bank's implied forecasts for domestic demand growth in 2008 and 2009 are 1.7% and 2.0% respectively. Westpac's own forecasts are 2.7% and 2.1% respectively and we estimate the Government's forecast to be 3.8% and 2.6%.

We do not believe that our forecasts over the two year period are sufficiently stronger than the Bank's to give the Bank concern if our forecast path proved to be more accurate.

We cannot say the same for the government's implied forecast for domestic demand growth. In the figure we set out our estimate of the RBA's forecast profile for domestic demand growth, our own and the government's.

Our blunt conclusion is that if the government's forecast for domestic demand growth proves to be shaping up as correct, then the Reserve Bank will get very nervous indeed.

We are expecting (and we assess the Reserve Bank is of a similar view) that domestic demand will hit a very soft patch in the year to June 2009, growing by only 1.6% compared to the government's assessment of 2.75%. We expect private final demand to slow even more to 1.2% in the year to June 2009 compared to the government's estimate of 3%.

In short, we expect that if the government is correct on the pace of the actual spending slowdown then the RBA will need to (on a no policy change basis) raise its inflation forecast, leaving it no alternative but to tighten policy.

Curiously, the government has forecast an inflation profile that has it slowing more quickly than the RBA expects. Underlying inflation is expected to print 4% for the year to June 2008 - down from 4.2% in the year to March 2008. To achieve 4%, an unrealistically low 0.7% increase would be required for the June quarter. It also expects underlying inflation to drop to 3¼% by June 2009 compared to the Reserve Bank's forecast of 3½%.

Despite its optimistic view on spending, the government is expecting a collapse in employment growth. Through the year growth in employment is expected to fall to just 0.75% by June 2009 from the current pace of 2.8%. That compares to our forecast of 1.1%. The lags between spending growth and employment coupled with the likely labour hoarding in the cycle make the government's style of slowdown very unlikely, particularly with its stronger spending profile.

The government's justification of its much stronger spending growth outlook seems to rely on the likely stimulatory impact of the terms of trade boost. We agree entirely on the terms of trade outlook and assess that the Reserve Bank is of the same view that this boost is the key risk to the forecast slowdown.

Our forecasts and those of the RBA are based on the transmission mechanism from the terms of trade to spending being more muted than recently as other factors associated with confidence and tight financial conditions dominate spending decisions.

However, if the government's domestic demand forecast (not their inconsistent employment outlook) prevails, expect the Bank to be tightening further in the second half of 2008.

Bill Evans, Chief Economist, Westpac, ph (61-2) 8254 8531

Australia: Data Wrap

Mar housing finance

• The total number of loans to owner-occupiers fell by 6.1% in March, following a 6.8% drop in February. Prior to that housing finance was relatively resilient.
• One word of caution - it is possible that weakness in March was exaggerated because of Easter. The ABS advise that they (attempt to) adjust for this effect.
• Our impression is that weakness in housing finance is genuine. There are a number of indicators pointing to a significant interest rate impact (eg retail sales, consumer confidence, auction clearance rates, dwelling approvals and house prices).
• Australians are delaying moving into the housing market as significantly higher interest rates bite. The RBA lifted official interest rates by 1.0% since August, including a 0.25% hike in March. In addition, mortgage rates have increased by more than this, as rising global capital costs are passed through.
• The question now is the full impact of higher rates. We anticipate further near term weakness in housing finance - with commercial banks raising rates in April. That said, the rate of decline is likely to moderate. Supportive factors are labour market resilience and an expected 20% jump in the terms of trade this year - which will inject up to 3% of GDP into the economy.

Q1 wage price index

• The headline Wage Price Index surprised on the downside in Q1 2008, rising 0.9%qtr (consensus 1.1%) allowing annual growth to edge down to 4.1%yr from an equal record high of 4.2% previously.
• While below expectations, the result is unlikely to be of any great relief to the RBA nor is it likely to alter their rhetoric on the pace of wages growth. Growth of 4.1%yr remains clearly above the full history average pace of 3.6%yr.
• The public sector outcome was yet again below the private sector. The private WPI rose 0.9%qtr taking annual growth to 4.1%yr from 4.3%, but it too remains well above its long run average of 3.5%yr. The public WPI rose 0.8%qtr lowering growth to 3.9%yr from 4.1%.
• Recent editions of the RBA Statement on Monetary Policy have been drawing greater attention to broader measures of wage inflation, noting the acceleration in the National Accounts measure of average compensation to around a 5%yr pace. A broader WPI measure than the headline series is for total hourly rates of pay including bonuses, which today showed a further acceleration to a new high of 4.7%yr (vs 4.5% prev) for all sectors, with the private sector subset pace rising to a record 4.9%yr (vs 4.6% prev).
• Subdued public sector WPI outcomes are unlikely to persist near-term, with Q2 and Q3 facing upside risks from the recent Victorian decision on teachers pay, and risks of a spillover to other states.

Q1 full-time AWOTE

• Full-time AWOTE (average weekly ordinary time earnings) rose 1.1%qtr in Q1 (vs 0.8% prev) nudging annual growth to 4.8%yr from 4.7% previously. This remains above its decade average growth rate of 4.56% (0.19ppt gap), but the pace has been remarkably stable over the past year, ranging between 4.6%yr and 4.9%yr. Private sector AWOTE rose 1.2%qtr (vs 0.7% prev) taking annual growth to 5.3%yr from 5.4%, maintaining a greater gap above its long term average pace than the all sector measure - the decade average pace for private sector AWOTE is 4.69% (0.64ppt gap). Public sector AWOTE rose 0.7%qtr (vs 1.1% prev) taking annual growth to 2.8%yr from 2.9%.
• With the RBA focussing more on broader measures of wage inflation, we note that in the private sector subset of this data, growth in full-time adults total earnings (not just ordinary-time) is stronger than that for AWOTE, and further beyond its decade average pace. Private sector full-time adults total earnings rose 1.4%qtr (vs 0.6% prev) lifting annual growth to 5.6%yr from 5.5% previously, the highest since 3Q2005, although here too, growth has been stable over the last three quarters. The decade average pace for private total earnings growth is 4.53%, so the current pace is 1.11ppts above its decade average.
• AWOTE is a volatile measure of the average wage bill faced by businesses in a levels sense, and is often distorted by changes in the composition of labour in the survey sample. As such, it is not usually a good guide to short run wage inflation trends. Given the persistent tightness of the labour market, it is surprising that average weekly earnings growth has been virtually steady for the last three quarters. But in accordance with the RBA's recent descriptions on labour costs, this data continues to show wage pressures above long-run averages, and more so for broader wage measures that include payments beyond ordinary-time earnings.

Round-up of local data released last week

New Zealand: The Week ahead & Economic Wrap

Countersunk

Data this week confirmed that the NZ economy slowed sharply in the March quarter. While the Reserve Bank will not change its mind as quickly as markets, we expect them to be in cutting mode by September. However, this week's data also confirmed hefty inflation pressures. We therefore see only modest rate cuts of 100 basis points to 7.25% by January. Despite the economy going into a hole, there is no guarantee that inflation will be fully tamed on the other side of it.

Housing market data for April from the Real Estate Institute confirmed ongoing weakness. Annual house price inflation ticked into negative territory for the first time (-1.1%), while sales remained around half of year-ago levels. Seasonally adjusted monthly sales bounced 14% after March's 31% fall, this volatility likely just reflects the unusual Easter timing. Days to sell continued to increase, from 42 to 45 (s.a.). The data are in line with our expectations that house price inflation will trough around -10% this cycle before flat-lining as affordability is gradually restored.

Food prices rose 0.3% in April, to be up 6% for the year, with more to come. Grocery prices rose 1.2% to be up a very chunky 10.7% over the year. Food prices feed directly into the CPI, and we expect a solid contribution in Q2. We have pencilled in 1.1% for the overall CPI, which would lift annual CPI inflation to 3.5% in Q2. The risks around this view are skewed to the upside, given recent increases in fuel prices. We expect annual inflation to jump up significantly more in Q3 - quite possibly through 4%.

Retail sales data for the March month (nominal) and quarter (real) were extremely weak, data which saw the NZD fall half a cent. Nominal sales in the March month fell 1.2%. We were wary that this might happen: we suspect that the timing of Easter pulled down March sales (on the past 4 occasions when Easter has fallen in March, retail sales have averaged a 1.5% drop in the month) and we expect a solid bounce back in April. Nonetheless the data have implications for consumption growth in Q1. Real sales fell 1.2%, dominated by car sales, which fell 6%. Other big ticket items are also suffering, particularly housing-related goods like furniture and floor coverings, hardware and appliances. The disparity between urban and rural fortunes continues to widen. Year-on-year, rural nominal retail sales are up some 5.5%, while urban sales are down 1.7%.

Consensus forecasts for our growth in trading partners were unchanged in May versus April, at 3.0% for 2008 and 3.2% for 2009. These data are an important input into the Reserve Bank's international growth forecasts, and despite the May robustness are sitting well below the RBNZ's March Monetary Policy Statement forecast (3.2% and 3.5%).

The producer price indexes were released today. These are of less importance in NZ than in Australia, due to their release after the CPI. However, they are of more interest than usual at the moment given the degree of cost push inflation pressures in the economy. Inputs rose a hefty 2.3% in Q1 (7.4% y/y), mostly reflecting higher energy prices, with input prices for electricity generation and supply up 42% over the quarter! Output prices rose 1.8% (6.1% y/y), with the largest contributor being the dairy product manufacturing index. That input prices are outpacing output prices suggests little relief for squeezed margins and profitability across much of the NZ business sector despite record-high surveyed pricing intentions. Inflation pressures are pervasive in the NZ economy, and a short, sharp slowdown may not be sufficient to unwind them completely. We therefore see room for only four cuts in the Official Cash Rate, from 8.25% to 7.25% by January next year.

In other developments, mortgage interest rates took a sizeable step downwards this week in response to lower wholesale rates as the market re-evaluated how soon the Reserve Bank may start cutting rates. Most people rolling over their fixed mortgages will still be facing a higher rate, but it now looks less scary than it did. The change of direction of interest rates may have a more positive impact on sentiment than the magnitude of the falls would usually warrant.

Next week brings April migration data, for which we expect a fairly flat result; electronic card transactions for April, where we anticipate a decent monthly bounce-back; and most importantly, the Budget on Thursday. Dr Cullen has been steadfastly hosing down expectations of the size of tax cuts. This is not surprising: the fiscal outlook has deteriorated significantly. With operating surpluses under pressure, we suspect threshold adjustments will be the first step, likely implemented from 1 October 2008. Any changes in the tax rates themselves will likely be pushed into later years and made contingent on ‘economic circumstances' at the time.

We expect the updated forecasts to show much weaker economic activity through 2008/09, resulting in reduced operating balance forecasts. From 2009, a much more positive growth outlook is likely to be projected. Excluding accounting and revaluation changes, the operating balance (OBEGAL) is tracking broadly in line with forecasts in the March 2008 half-year fiscal update. However, with the repurchase of the rail system due for settlement on 20 June 2008, and the economy now slowing dramatically, the risk is the Government finishes up the year with a cash deficit. Bigger spending commitments combined with reduced revenue growth will see an increased borrowing requirement over the next four years. We expect the Bond Programme to average $3.2bn in each of the next four years - up from an average $2.5bn forecast in the HYEFU.

Round-up of local data released last week

Data previews

Aus May Westpac-MI Consumer Sentiment

May 21, Last: 87.4

• The Westpac-MI Consumer Sentiment Index slipped another 1.3% lower to 87.4 in April, the lowest read since June 1993. The fall extended the cumulative decline since the start of the year which remains the sharpest drop-off in sentiment since the survey was first conducted in 1975. Notably, April saw sentiment fall sharply for households who rent, reflecting the worsening shortage and rising cost of rental accommodation.
• The May survey was delayed a week in order to capture the full reaction to the 2008-09 Budget. The survey is in the field from May 13 to 18. Other than the Budget, factors that are likely to influence sentiment include: official rates again staying on hold in May (but more market-led increases in mortgage rates of ~10bps); continued signs of improvement in global financial markets; but more oil prices rises (to over US$126/bbl) and weakening housing markets locally.

Westpac-MI Consumer Sentiment Index

NZ Budget 2008

May 22, Last: $5,339mn, WBC f/c: $6,370mn

• The Government's 2008 Budget will be released on May 22.
• We expect the updated Economic and Fiscal forecasts to show much weaker economic activity through 2008/09, resulting in reduced operating balance forecasts.
• Bigger spending commitments combined with reduced revenue growth will see an increased borrowing requirement over the next four years. We now expect the Bond Programme to average $3.2bn in each of the next four years - up from an average $2.5bn forecast in the HYEFU.
• The Budget will deliver personal tax cuts but the electorate is likely to be disappointed by their size.

NZ Government Operating balance*

US Apr producer price index

May 20, Headline Last: 1.1%, WBC f/c: 0.6%

May 20, Core Last: 0.2%, WBC f/c: 0.2%

• The PPI surprised to the upside in March, with energy prices up 2.9% and food up 1.2%, lifting the headline rate 1.1%. However the core rate was better behaved at 0.2%, its lowest for the year so far, constrained once again by falls in auto and light truck prices.
• April import price data showed petroleum prices up 4.4% although we expect energy prices overall will rise less steeply than in March, particularly after seasonal adjustment (note the soft April CPI). There is also some evidence that food prices might have corrected temporarily lower in April although it is unclear whether the PPI survey was timed to catch that. Weak auto sales in April may reflect less price discounting to dealers.
• We expect a 0.6% headline PP gain with downside risk from food and a 0.2% core PPI rise with upside risk from autos.

US PPI inflation up on oil prices

US Apr existing home sales

May 23, Last: -2.0%, WBC f/c: -2.0%

• Existing home sales fell 2% in March, to a level higher than in December and January, suggesting that sales might be finding a base. Since the start of Q4 last year, this sales measure has fallen just 2.5%.
• However new home sales have kept falling to new cycle lows and pending sales of existing homes (ie agreed but not finalised sales) have fallen by 8% since the start of Q4 last year. That suggests more weakness ahead for existing home sales, which we expect fell another 2% in April, to a new cycle low of 4.83mn annualised.
• The report will also include price estimates. In March, median home prices were down 7.7% on year ago levels; we expect to see double digit annual price declines on this measure within the next few months.

US housing sales

Westpac Institutional Bank
http://www.westpac.com.au

Disclaimer

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