Australia's economic growth in 2018 looks set to undershoot the RBA's lofty expectations

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Australian economic growth looks set to undershoot the Reserve Bank of Australia’s (RBA) lofty expectations next year, at least according to the latest Westpac-MI Leading Index released today.

The Leading Index, a gauge on likely economic growth compared to trend looking three to nine months in the future, came in at -0.1% in July, up from -0.54% in June.

While a small improvement, the index suggests that growth in the first half of next year will be marginally below Australia’s trend growth rate, widely perceived to be around 2.75% per annum.

The RBA is currently forecasting that GDP will grow by 3% over the year to June 2018, well above the level indicated by the Leading Index.

“Despite the improvement in the growth rate it remains negative for a second consecutive month pointing to below trend growth momentum and a sharp turnaround from strong positive, above trend reads at the start of the year,” said Bill Evans, chief economist at Westpac.

“The Index growth rate has slowed from 1.11% above trend in February to 0.10% below trend in July, a deterioration of 1.21 percentage points.

Source: Westpac

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According to Evans, two of the surveys eight components accounted for almost all of the reversal in the index over the past six months: commodity prices and yield spread.

As a result of falling prices for Australia’s key commodity exports, it alone sliced a massive 1.63 percentage points of the headline index.

A flattening in global bond curves since the beginning of the year, partially reflecting softer US economic data and increased doubts that Donald Trump will be able to deliver increased infrastructure investment and tax cuts to the US economy, also wiped off 0.43 percentage points from the index.

Those declines have largely offset a modest improvement in the indices domestic components such as a bounce in total hours worked and improved unemployment expectations.

This table shows each components contribution to the index over the past x months.

Source: Westpac

Although the movements in the index have been volatile, Evans says that it still points to the likelihood that growth will undershoot the RBA’s expectations next year.

“While the index only gives us a glimpse of the likely momentum in the first few months of 2018 it currently seems to be more consistent with our own view of the likely growth environment in 2018 than the forecast recently released by the Reserve Bank.”

Westpac is currently forecasting that Australian GDP will grow by just 2.5% next year, below the 3.25% level seen by the RBA.

Given that outlook, Evans remains of the view that official interest rates will remain unchanged until at least the end of 2018, putting him at odds with financial markets and an increasing number of economists who are forecasting that rates will start to increase at some point next year.

“It is interesting that in the Bank’s Board minutes which were released on August 15 it sounded less confident about achieving its inflation target,” he says.

“We concur and, consistent with below trend growth, expect that rates will remain on hold through 2018.”

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