Inflation Contained, Economy Picking Up, but Likely Tight Budget May Drag Growth

Latest economic news shows some promising signs for the Australian economy. However, the new government’s first budget, to be announced on 14 May, is a big unknown. The CAMA RBA Shadow Board is 74% confident that the cash rate should remain steady at 2.5%. The probability attached to a required rate cut equals 6% while the probability of a required rate hike has fallen to 20%.

The unemployment rate fell to 5.8% in March while full time employment fell by 22,000 and the participation rate edged down to 64.72%. Monthly job vacancies remained strong, only 1% below the long-run average.

Inflation lies barely above the middle of the RBA’s target band of 2-3%. The Australian dollar has held up during the past month, now valued at 93 US cents. Asset markets, in particular housing, remain buoyant. Domestic consumption and production indicators are continuing on their modest upward trend.

Internationally, the clouds appear to be lifting ever so slightly. US economic data is improving and the Federal Reserve Board announced a further reduction of its asset purchasing program. Several European crisis countries, foremost Greece, are finally showing signs of rebounding. In particular, their increased access to international credit markets at favourable conditions has surprised many analysts. China’s growth is slowing, and the possibility of a credit crunch remains real, but a growth rate of 7% is considered by many to be a lower bound.

The big unknown for Australia is the forthcoming federal government budget. It will likely be contractionary for the economy overall as the Coalition government seeks to reduce spending in a long-term effort at balancing the budget. Moreover, there is much speculation about the distributive implications of the budget. If the budget turns out to be tight and regressive, it will reduce aggregate demand and increase the likelihood that interest remain low.

The consensus to keep the cash rate at its current level of 2.5% has strengthened slightly. The Shadow Board’s confidence in keeping the cash rate steady equals 74% (71% in April 2014). The probability attached to a required rate cut equals 6% (4% in April) while the probability of a required rate hike has fallen to 20% (25% in April).

The probabilities at longer horizons are as follows: 6 months out, the probability that the cash rate should remain at 2.5% edged down to 37% (39% in April). The estimated need for an interest rate increase is virtually unchanged at 48%, while the need for a decrease has risen slightly to 16% (12% in April). A year out, the Shadow Board members’ confidence in a required cash rate increase has dropped 8 percentage points to 59%, the need for a decrease rose to 18% (down from 14% in April), while the probability for a rate hold has increased to 23% (down from 19% in April).

Note: Mardi Dungey was unable to vote in this round, so the linear opinion pool aggregate is based on the remaining 8 members.