Australian & New Zealand Weekly

Week beginning 21 July 2008

• Underlying inflation to hit 4.5%. No rate relief until 2010.
• Australia: Q2 PPI & Q2 CPI.
• RBNZ to cut rates - question is will they hold off until September.
• UK Q2 GDP - growth still positive, but likely stalled or negative in Q3.
• BoE minutes - any additional votes for a rate cut?
• US events: Fed speak, Beige book, housing data, durable goods.
• Key economic & financial forecasts.

Underlying Inflation to Hit 4.5%. No Rate Relief Until 2010

We will receive the next instalment of the inflation story for Australia on July 23 next week. The June quarter Consumer Price Index will be released at 11:30 am with the Bureau of Statistics providing numbers for both headline CPI and the trimmed mean and weighted median which are the two measures of underlying inflation which the Reserve Bank uses to calculate its measure of underlying inflation. Note that these measures are provided to one decimal place.

Westpac replicates the RBA's methodology and provides its customers with equivalent numbers to two decimal places. This additional information can be important since it can sometimes provides useful insight into whether the number is say a "hard" 1% (1.04%) or a "soft" 1% (0.95%). With markets so sensitive to small nuances in these inflation numbers this "hard" / "soft" distinction is useful.

On Thursday we released our detailed forecasts for the CPI. We expect that headline CPI will print at 1.2% (4.2% annual); trimmed Mean at 1.2% (4.3% annual); and weighted median at 1.2% (4.6% annual). After adjustment for rounding we expect the average of the two underlying measures to print 1.2% (4.5% annual).

This will push the annual underlying read up from the March quarter level of 4.2% to 4.5%. Headline annual will remain at 4.2% unchanged from the March read.

This read will not be sufficient to elicit any policy response from the RBA

In the past two quarters annual underlying inflation has jumped by 0.58% and 0.6% respectively - that compares with the average increase in previous quarters of only 0.18%. We estimate that the jump in annual underlying will be 0.26% in the June quarter - a distinct slowing in the pace of increase we have seen in recent quarters although still above the average increase in more stable times.

The size of the quarterly rise is expected to stabilise at 1.2%. In recent quarters we have seen a distinct acceleration in quarterly increases. In March 2007 the quarterly underlying read was 0.61%; followed by 0.95% (June 2007); 0.93% (September 2007); 1.09% (December 2007) and 1.21% (March 2008).

Should our June forecast of 1.2% prove correct, the RBA can at least argue that, in a quarterly sense, inflation pressures appear to have peaked. Of course in annual terms that peak is likely not to be reached until the September quarter. If we assume, say, a modest drop in quarterly inflation in September from 1.2% in June to 1.0% in September annual inflation will still rise to around 4.6%. Without that drop in September the Bank's task of lowering annual underlying inflation to 2.75% by end 2010 would seem to be formidable indeed. For example, a further step up in quarterly inflation in September to say 1.4% would see annual inflation "blow" to around 5% truly testing the Bank's patience.

In contrast, if we are really at the high point of the quarterly numbers (as Westpac expects) then improved annual reads can be expected from the December quarter. For example, a 0.9% read in December following a 1% in September would see annual underlying inflation fall from 4.6% to 4.4% with say a 0.8% in March giving an annual measure of 4% in March 2009.

Since the inflation target was adopted and underlying inflation was first calculated by the RBA the best "performance" in reducing underlying inflation was in the period from December 1995 to September 1997 when annual underlying inflation was reduced from 3.12% to 1.62% - an "improvement" of 1.5ppt's. After the Bank had observed underlying inflation falling from 3.12% in December 1995 to 2.73% in June 1996 it felt sufficiently "emboldened" to begin cutting rates with the first cut coming at the August Board meeting following the release of the June quarter CPI in late July. That reduction in the CPI inflation was in lagged response to the slowdown in domestic spending growth from 6.5% through 1994 to 2.5% through 1995 and 3% through 1996.

Even with our expectation that quarterly inflation pressures are likely to be reported to have peaked in the June quarter the RBA faces a much more daunting task with respect to moving inflation back within the target range than we saw in 1996. To be sure the Bank was prepared to ease rates after it had seen a 0.4ppt fall in annual inflation and an 18 month period of very weak growth but that fall was from a much lower starting point (3.12% compared to a likely 4.5-4.7%) and for that reason the extended period of weak growth in this cycle will likely need to be longer.

The Bank's current inflation forecast is that underlying inflation will have reached 3.5% by June next year. That was on the basis of a 4.2% starting point. After next week that starting point is likely to have risen to 4.5% with a possible 4.6%-4.7% by September. That 3.5% forecast is likely to be sharply revised upward. In a Bulletin released on July 17 the Governor noted "Inflation is currently running at over 4 per cent and likely to be around that level for another year or so on most recent forecasts".

That suggests that following the release of next week's CPI the Bank could be raising its June 2009 underlying forecast to 4% from the current 3.5%. A fall in underlying inflation of 0.5%-0.7% over three quarters (September 2008- June 2009) is broadly consistent with the "best" performance in 1996 but unlike that period when such a fall was enough to prompt the beginning of the rate cut cycle underlying inflation would STILL be 1% above the top of the target zone - a very dangerous place to begin an easing cycle.

Of course growth in the economy might slow much more sharply than we saw in the 1995-1996 period (that slowdown profile is our current forecast and that of the RBA with the government's forecasts being decidedly more upbeat) but we would be very surprised to see a much sharper improvement in underlying inflation than we and the RBA are forecasting.

We are not surprised that markets have moved to price a rate hike probability back from near 200% in June to a lowly 2% today. The two key aspects to Westpac's forecast that we have maintained since early March have been no further increase in rates but no cuts until 2010H1. These are predicated around a sharp slowdown in growth in 2008 and sustained weakness in 2009. Inflation will be slow to fall in lagged response to the slowdown limiting the RBA's options to cut rates until 2010.

Markets are poised to price rate cuts into the curve for the first half of 2009. Next week's inflation report is unlikely to provide much comfort there but it is very difficult for us to see a measure for underlying inflation much above our forecast of 1.2%. In fact our current read of the RBA's "mood" is that a number as high as 1.5% and an annual read of 4.8% would still see the RBA maintaining steady policy until it could gauge the impact of the tightening of financial conditions on growth and inflation.

Australia: Data Wrap

Jul RBA meeting minutes

• As expected, the minutes of the 1st July RBA Board meeting confirmed the case for steady policy.
• Key themes remain unacceptably high inflation and risks to inflation expectations, the pace of current demand and the risk of domestic demand finding a second wind given the terms of trade jump.
• On the question of the pace of current demand, the issue has been resolved. The minutes acknowledge the recent evidence that the current stance of policy is working to restrain demand. The rise in fuel costs and tighter financial conditions, because of the deterioration in financial markets, are also acting to limit demand.
• On the sustainability of the demand slowdown, that remains uncertain. The Bank remains concerned that "... the rise in the terms of trade ... could translate into renewed growth in spending".
• On inflation, the Bank expects the June quarter CPI to show another high reading (the RBA estimates headline inflation of "over 1% in the June quarter"). The concern is that "... these high outcomes risked lifting inflationary expectations and/or wage demands. If that occurred, it would make inflation more difficult to reduce over time".
• We were not surprised by the tone of the July minutes. There is no doubt that the starting point for inflation is now higher than previously expected given the oil price shock. However, with the significant slowing of domestic demand that is now clearly evident, inflation is still likely to return to the target band by late 2010.
• Westpac remains comfortable with our view that rates will remain on hold for a long period, with the first rate cut not being possible until the Bank sees 12 to 18 months of growth in domestic demand of around 2%. That points to rates remaining on hold until the first half of 2010.

May Westpac-MI Leading Index

• The annualised growth rate of the Westpac-Melbourne Institute Leading Index, which indicates the likely pace of economic activity three to nine months into the future, was 2.1% in May, well below its long term trend of 3.9%. The annualised growth rate of the Coincident Index was 3.0%, also below its long term trend of 3.8%.
• This result is entirely consistent with the prospect that the Australian economy can be expected to slow further through 2008 and into 2009. Over the last six months the growth rate of the Leading Index has fallen sharply from 6.5% to 2.1%. That is the sharpest six month fall in the growth rate since February 2001 when the introduction of the GST and the cumulative impact of 1.5% of RBA tightening from November 1999 to August 2000 severely disrupted the housing and labour markets.

Q2 trade prices

• Export prices surged 13.5% in Q2 after a 3.5% rise previously, led by sharply higher prices for bulks (coal, metalliferous ores reflecting iron ore) and petroleum, with partially offsetting falls in gold and textile fibres.
• Import prices were tamer than expected, rising 1.4% in Q2 after a 2.7% rise previously. Petroleum prices rose 15.9%, slightly below our 18% forecast, while food and beverage prices were much more subdued with a 0.2% rise (vs 4.7% previously). Also, after abstracting from these non-core items, core import prices fell 1.4% reflecting some benefit from a 3% rise in the import weighted TWI, in contrast to Q1 when core prices rose 1.1% despite a 1% TWI rise.
• The data has no implications for our CPI forecast - the link between import prices for consumer goods and the CPI is poor - while the near flat result for imported food prices reaffirms our forecast for much more subdued food group prices in the CPI relative to Q1. However, the data has nudged down our PPI forecast. The greater dampening influence of AUD strength in core import prices relative to last quarter necessitates a downward revision to core import prices in the PPI, and with a lower than expected jump in petroleum, nudges our Q2 PPI forecast to 1.2%qtr and 4.9%yr (from 1.3%qtr f/c prior to the data).

Round-up of local data released last week

New Zealand: The Week ahead & Economic Wrap

Next week's OCR review will be a finely balanced decision, but we lean towards no move until September. The RBNZ set out a slow and steady approach in their June Monetary Policy Statement, balancing the risks of a sharper growth slowdown against the risks of having to make an embarrassing policy U-turn if inflation fails to moderate. We don't think enough has changed since then for the RBNZ to abandon their plan.

Monday's retail sales figures showed a sharp 1.2% drop in May, dominated by a 14.8% fall in motor vehicle sales. The car market is under more pressure than most from tight credit, high interest rates and rising petrol prices, with petrol breaching the psychologically important $2/litre mark in May. Excluding the auto-related sectors, retail sales were up 0.7%, driven by a 3% rise in supermarket sales. However, a 1% increase in food prices during the month suggests that volume growth remained weak - we suspect that real consumer spending in Q2 was even weaker than the -0.4% recorded in Q1.

Meanwhile, New Zealand's inflation problem is getting worse. The 1.6% rise in the CPI in Q2 was on our expectations, but higher than the 1.4% expected by the market and the RBNZ. The annual rate of inflation rose to 4.0% in Q2 from 3.4% in Q1. Cost pressures were evident throughout the CPI data, the most obvious being a hefty 12.8% quarterly rise in petrol prices and a massive 29% increase in diesel prices. Higher fuel costs also flowed through to other goods and services such as airfares. Household electricity prices rose 3.6%, and housing construction and maintenance costs rose on higher raw material costs.

Annual non-tradable inflation fell slightly to 3.4%, matching RBNZ and our forecasts. However, with the government subsidy changes from last year due to drop out of the annual calculations next quarter, along with the second-round effects of recent cost increases, we expect annual non-tradable inflation to rise to 4.5% in short order.

For policy purposes, the rise in annual inflation rate is not a direct concern for the RBNZ - they focus on forecast inflation 6-12 quarters ahead, enough time for this week's figures to drop out of the annual calculations. However, past inflation matters to the extent that it can flow through to expectations of future inflation. The RBNZ is hoping that this won't happen - or if it does, people won't be able to act on it by raising their prices or demanding a pay rise. The RBNZ's assumption may prove to be right, but history is not on their side.

This risk of inflation expectations blowing out is one of the reasons why the RBNZ signalled a gradual approach to easing in its June Statement. Their projections assumed over 200 basis points of cuts over the next few years, but weighted more towards the later years, once they see inflation more comfortably within the 1-3% target band. And when presenting this to Parliament, RBNZ Governor Bollard noted that “our numbers are consistent with, for example, a cut in September and, for example, another cut in December”. Looking back at past statements, we can't find a single instance where he has been this explicit about his next move and hasn't delivered on his word.

So the case for a July rate cut rests on whether conditions have changed enough since June for the RBNZ to abandon its long-term plan. The risks to growth have certainly increased: we expect another contraction in GDP in Q2, meeting the technical definition of a recession. World growth forecasts have also been revised down, and credit markets have tightened up again.

What hasn't changed, though, is the risk of creating fresh problems further down the track. The RBNZ was already forecasting inflation to peak at 4.7% in Q3; we now think it will be more like 5.5%. And that's before considering the likely effects of an aggressive easing cycle, the first of which would be a sharply lower currency. This would see near-term inflation shoot even higher, and probably wouldn't do a lot for confidence either - we doubt that consumers and businesses would appreciate petrol at $2.50 a litre or more. You don't have to look hard to find other central banks that have already painted themselves into a corner this way.

We certainly wouldn't rule out a rate cut next week. But there is more at stake than a matter of timing. The RBNZ is about to embark on a new easing cycle that could be drawn-out or short-lived; the risks around both inflation and growth are as high as they've ever faced; and markets will take the RBNZ's first move as a sign of how it means to continue. The best way to balance these risks is to maintain the slow and steady track that they have already signalled.

Round-up of local data released last week

Data previews

Aus Q2 PPI

Jul 21, Last: 1.9%, WBC f/c: 1.2%

Mkt f/c: 1.5%, Range: 1.0% to 2.5%

• The Q1 PPI spiked 1.9%qtr (record rise) and 4.8%yr. Non-core items added more than expected (0.66ppts) with a strong fuel price rise reinforced by food prices. Core import prices fell 0.1% with the AUD TWI up 1%. But broadly based pressures saw domestic core ex-construction spike 1.4% and with building prices up a strong 1.9%, overall core PPI jumped 1.5%qtr and 3.3%yr.
• The 3% AUD TWI rise in Q2 implies tame core import prices (-1.0%) and we expect more subdued domestic core ex-construction (0.7%) and building construction (1.4%) prices with fading demand. This gives a tamer 0.8%qtr core PPI. Food prices are expected to slow to a 0.5% rise but with a stronger surge in petroleum (13.9%), this lifts the total PPI 1.2%qtr, raising the annual rate to 4.9%yr (highest since 2000Q4).

PPI: qtly fuel, bldg, domestic core pressure

Aus Q2 CPI

Jul 23, Last: 1.3%, WBC f/c: 1.2%

Mkt f/c: 1.2%, Range: 1.0% to 1.4%

• Our headline CPI forecast for Q2 is 1.2%qtr, 4.2%yr. Petrol adds 0.40ppts, rents add 0.11ppts, house purchase adds 0.11ppts, hospital & medical services add 0.11ppts and deposit & loan facilities add 0.09ppts. Main group pluses are in transportation (petrol), housing (rents, house purchase, gas), financial & insurance services (base effect of Q1 hikes), health (fund premiums), food, and household contents and services (rebound from New Year sales, but less than usual with flagging spending). No group is likely to subtract, but areas of discretionary retailing like clothing should see smaller than usual seasonal rebound.
• Our average RBA underlying CPI forecast is 1.2%qtr (vs 1.2% prev) lifting the annual rate to 4.5%yr from 4.2%, the highest since 1991Q2. Large rises in big weighted items like petrol will leave other strong rises in trimmed mean, and scant price falls likely to all drop out, keeping quarterly pace 'high'.

Inflation: RBA underlying CPI to hit 4.5%yr

RBNZ OCR review

Jul 24, Last: 8.25%, WBC f/c: 8.25%, mkt f/c: 8.25%

• The RBNZ's June Monetary Policy Statement indicated that they will be in a position to lower the OCR later this year. With growth deteriorating further since then, market opinion is divided as to whether they will start in July or September.
• It will be a finely balanced decision, but we favour a September move. The RBNZ clearly detailed a slow and steady approach in their June Statement, balancing the risk of a sharper growth slowdown against the risk of having to make an embarrassing policy U-turn if inflation expectations fail to moderate. We don't think enough has changed since then for the RBNZ to abandon that approach.

NZ OCR and 90 day rate

US Jun existing & new home sales

Jul 24, Existing home sales Last: 2.0%, WBC f/c: -2.5%

Jul 25, New home sales Last: -2.5%, WBC f/c: -2.0%

• Existing home sales have held in a 4.89-5.03mn annualised sales range since the start of this year, which suggests that sales might be bottoming out. However pending sales of existing homes fell nearly 5% in May, leaving them down 1.4% from the end of last year. That compares to existing home sales up 1.4% over the same period. So we see risk of a renewed stepdown in existing home sales mid year.
• New home sales fell 2.5% in May but not to a new cyclical low - that was in March. That too was suggestive of sales bottoming out, but with the inventory of unsold homes equivalent to close to a year's worth of sales; single family house starts falling to new lows in May-June; homebuilder sentiment slumping mid-year; and mortgages still hard to get, we see new home sales showing renewed weakness in June.

US Jun durable goods orders

Jul 25, Last: flat, WBC f/c: -0.5%

• Durable orders failed to grow for the third month running in May. 11% gains for both civilian aircraft and defence flattered the unchanged May result, but ex transport and ex defence orders both declined, as did core capital goods orders outside of defence and aircraft.
• The regional Fed factory surveys all had weak orders readings in June, although the slippage in the national ISM was only minor. Outside of autos, manufacturing contracted 0.1% in June. These numbers point at best, to a subdued orders picture.
• Boeing saw little change in the number of aircraft orders in June relative to May. Defence, up two months running, is at risk of a modest decline. Taken together, these factors point to a loss of 1% or more, except that we expect a post-strike bounce in auto orders to limit the headline decline to just 0.5% in June.

US durable goods orders

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