Analysis: RBA’s Inflation Forecasts More Uncertain As Exch Rate Impact Set to Fade

• Published on
• 21 Nov 2019, 05:21 AM

By Sophia Rodrigues

The lower exchange rate has been an important driver of Australia’s inflation for over a year but its support is expected to diminish over the next year, raising questions on the outlook for inflation, and thus for the Reserve Bank of Australia’s monetary policy.

For the first time in 18 months, the RBA said the effects of the earlier exchange rate depreciation is expected to wane in the coming year. This is significant because the lower exchange has been an important contributor to inflation in the past year through its impact on retail prices, mainly consumer durables.

In recent quarters retail prices rose to be 1.5% higher over the year, which was the highest rate of retail inflation in around a decade. There was broad-based increase in consumer durables inflation, with price increases across motor vehicles, clothing & footwear and some household goods.

The RBA expects the upward pressure on consumer durables prices from the exchange rate depreciation over the past year to wane over 2020. So any rise in consumer durables prices would depend on pick-up in consumer demand and any easing in competition dynamics in the industry.

UNCERTAINTY ABOUT OFFSETTING INFLATION SOURCES

The worry is not that the impact of exchange rate depreciation would diminish but the uncertainty around what inflationary pressures would offset this decline.

One component that is expected to support inflation is gradual rise in rent though this would depend on strong population growth more than offsetting the slower additions to the housing stock.

New dwelling inflation is expected to remain subdued until housing construction starts to pick up in 2020, so any delay in construction pick-up would mean this component of inflation would remain low for longer.

There are also continued risks on administered and electricity prices front. The RBA estimates that the downside risks to these prices have largely materialized over the past year but any rise in electricity prices is expected to be at below-average pace. There is also some risk that it could decline because there will be more renewable energy options.

ABOVE-TREND GROWTH?

Other than this, the RBA’s inflation forecasts rely heavily on above-trend growth and tightening in labor market conditions, and there is lot of uncertainty of either of these materializing.

In the minutes of the November board meeting, the RBA said inflationary pressures would pick up in response to above-trend growth in output and gradually tightening labor market condition.

This means for inflation to increase, the economy has to record above-trend growth and the labor market has to gradually tighten, and more importantly it should lead to an acceleration in inflation.

Westpac-Melbourne Institute’s leading index for November, published on Wednesday, pointed to weak economic momentum carrying well into 2020. According to Westpac’s chief economist Bill Evans the below trend theme signalled by the index is consistent with his own forecast for 2.4% GDP growth in 2020 whereas RBA is more optimistic with a 2.8% forecast.  Moody’s Investors Service has a still lower forecast of 2.3% for Australia’s GDP next year.

The ANZ Job Ads, one of the leading indicators of the labor market, fell in October and was at the lowest level since January 2017.

The RBA, however, remains optimistic about labor market prospects. In the November Statement on Monetary Policy, the RBA said leading indicators suggest positive labor market conditions will persist over the next six months. It noted job vacancies had declined a little but remain at a high level, and firms’ hiring intentions remain above average.

Even if the labor market evolves in line with the RBA’s expectation and growth is above-trend, there is still no certainty that inflation would increase as forecast. This is because of the risk that an extended period of low wages growth and inflation could mean that wage-setting norms would be slow to move higher. There is also a risk that the increase in superannuation guarantee from 2021 could affect wages growth.

A gradual lift in wage growth is important for gradual rise in inflation. But until that happens there is downside risk to RBA’s already subdued inflation forecasts which means it would be forced to lower the cash rate again.

How soon that happens would depend on how the data and more importantly how the exchange rate evolves.

--Contact: sophia@centralbankintel.com