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Economic Update – Feb 2011

Published on 11/03/2011

Glenn Baker, Chief Economic Adviser

The decision by the Reserve Bank Board to keep the cash rate steady at 4.75% in February reflects softer than expected inflation data and the short term impact of the Queensland and Victorian floods on business activity. However there are clear signs the Reserve Bank will need to further tighten interest rates later in 2011.
Since the last meeting of the RBA Board held in early December the inflation data continued to show moderation in price pressure in the economy. The Consumer Price Index (CPI) rose by 2.75%. Underlying inflation measures, which the RBA focuses on, fell further to be around 2.25% which is at the bottom of the target band of 2% to 3% that the RBA looks to maintain. This indicates that inflation is not an immediate threat to the economy and in current trend terms has been moving lower. The RBA has expressed the view that inflation should remain subdued for some months.
The floods have had a significant impact on economic activity at the beginning of this year. This is particularly so for areas in Queensland where agriculture (fruit and vegetable production) and mining (coal) have been hard hit. Additionally, there has been a general disruption to business activity. The reduced activity will lower national economic growth in the early part of 2011. At the same time the disruption to supply of certain products, principally fruit and vegetables, has led to sizeable price increases. Whilst this will have an adverse impact on the CPI lifting the headline view of inflation, the RBA’s practice in the past with disruptions like this caused by natural disasters has been to look through the raw short term data to the more medium term view of inflation. This means that the RBA is highly likely to hold to its current view that inflation will remain subdued for some months, potentially well into 2011.
Adding to the softer view of economic activity has been restrained retail spending, lower levels of consumer borrowing and an associated increase in the savings rate.
So in the short term it can be reasonably expected that the official interest rate will remain on hold.
The longer term picture, however, continues to one in which there will be a resumption of tighter monetary policy settings through further increases in the official cash rate.
The immediate effects of the floods will pass and economic activity will pick up, albeit that this will be a progressive and uneven recovery path. The task of rebuilding in effected areas will also add to economic activity over time. The ‘reversal’ of the flood effect is most likely going to coincide with a general lift in other sectors of the economy, principally mining and the associated export of commodities such as iron ore and coal. Australia is enjoying historically high terms of trade thanks to record commodity prices and this has been driving and will continue to drive significant growth in national income. Investment levels are increasing in response to the favourable conditions and this will facilitate a further uplift in activity as we move through 2011. The level of growth in the second half of the year in particular is likely to be quite significant as these factors come together. Additionally, there are increasing signs that the global economy is moving to higher and more sustainable rates of growth as the U.S. and Europe continue to emerge from the recessionary past into improving growth positions. China and India are maintaining high rates of growth and this is continuing to boost the outlook for Australia.
The brighter growth outlook for Australia is unfolding against an already tight labour market backdrop. Jobs growth over 2010 was very strong and the unemployment rate fell sharply. Whilst in the immediate period employment growth appears to be slowing down there is limited capacity to support a higher level of demand into the future. Capacity constraints and skill shortages are expected to emerge as we progress into the latter part of 2011 and this is very likely to bring with it wages pressure as demand for skilled workers exceeds supply. There have already been signs in recent months that wages growth is starting to accelerate after a relatively long period of moderate growth since the initial impact of the global financial crisis was felt. Wages pressure will generally add to price pressures which will also be emerging due to the impact of an improving economic outlook and an elevated demand for goods and services.
As this scenario unfolds the RBA is going to need to act to contain inflation, to ensure that the economy does not overheat and that sustainable growth rates can be maintained. Therefore, it is highly likely that the RBA will move to tighten monetary policy in the second half of 2011. The extent of this action will probably see the official cash rate raised by 0.5% taking it to 5.25% by the end of the year.

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