The RBA's optimism means a lot has to go right in the Australian economy before interest rates rise

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  • The Reserve Bank of Australia (RBA) sees faster economic growth, lower unemployment and inflation pushing back towards the midpoint of its target over the coming years.
  • That combination suggests it’s edging closer to raising official interest rates, albeit not in the near-term.
  • Despite it’s growing optimism, it admits there’s plenty of uncertainty in relation to the housing market, household consumption and the inflation outlook.
  • Domestically, wage growth will largely determine whether it’s ambitious forecasts will be achieved.

The Reserve Bank of Australia (RBA) sees faster economic growth, lower unemployment and inflation pushing back towards the midpoint of its target over the coming years.

In other words, it’s moving closer to raising interest rates for the first time since late 2010.

Here are the bank’s latest forecasts from its quarterly Statement on Monetary Policy (SoMP) released today, including those that were offered three months ago.

RBA

The forecasts assume the Aussie dollar and oil prices will remain around the same levels as today, along with population growth remaining at 1.6% over the forecast horizon. They also incorporate financial market expectations for movements in the cash rate. A 25 basis point increase is not fully priced in until the middle of 2020.

With Australian economic growth soaring in the first half of the year, it’s forecast profile for GDP growth has been raised with the bank now expecting the economy to grow 3.5% in the year to December, faster than the 3.25% level it saw in August.

Further out, the economy is seen growing at an year-ended pace of 3.25% until the middle of 2020 before slowing to 3% by the end of its forecast range.

While similar to what was presented in August, the RBA now expects growth to be be a little faster, and longer, in the years ahead.

RBA

Crucially, it’s entire GDP growth profile is above the 2.75% “trend” level where inflation and unemployment levels are expected to remain steady.

Given that view, it also sees unemployment falling a little further, and inflation rising a little faster, than what was the case three months ago.

It sees unemployment holding at its present level until the end of next year before dipping to 4.75% by the middle of 2020 as faster economic growth helps to soak up excess capacity in the labour market.

Previously, it didn’t see unemployment breaching 5% over the entirety of its forecast horizon.

With stronger economic growth helping to reduce unemployment and, in all likelihood, wage pressures, the RBA also sees underlying inflation lifting a little faster than it did before.

After growing by just 1.75% in the year to September, it sees underlying inflation lifting to the bottom of its 2-3% target band by the middle of next year before rising to 2.25% by the end of 2019, a level where it is then expected to remain.

RBA

Importantly, it still doesn’t see underlying inflation hitting the midpoint of its target, an outcome that will likely prevent a near-term rate hike should its forecasts be correct.

It also suggests that when rate hikes do potentially arrive, they’ll likely be small and staggered in nature based on the RBA’s forecast profile.

However, combined with faster growth and lower unemployment, it does suggest the RBA is moving closer, rather than away, from starting to tighten policy.

“The board is expecting further progress in reducing unemployment and ensuring inflation is consistent with the target,” the RBA said.

“If that progress is made, higher interest rates are likely to be appropriate at some point.

“However, given the expected gradual nature of that progress, the Board does not see a strong case to adjust the cash rate in the near-term.”

Helping to explain the RBA’s more optimistic forecasts, it pointed to a variety of factors that should help to support economy over the coming years.

“GDP growth in Australia’s major trading partners is expected to be above trend over the forecast period, although a modest slowing is anticipated,” it said in relation to international factors.

Domestically, it said stronger labour market conditions should help to support household consumption and business investment.

“Accommodative monetary policy and tighter than anticipated labour market conditions are expected to provide ongoing support to growth in household income, consumption and business investment throughout the forecast period,” it said.

Importantly, it also expects household consumption, the largest part of the Australian economy at nearly 60%, to remain around current levels over the forecast horizon.

“Household consumption growth has been fairly stable at around 3% in year-ended terms and is expected to continue at around this rate,” it said.

“Consumption growth is expected to be supported by ongoing growth in employment and a modest pick-up in wages growth.”

However, despite that optimistic assessment on the largest part of the economy, the RBA put a major caveat on that view.

“There continues to be uncertainty about how quickly the unemployment rate will decline and how quickly that will feed into wage pressures and inflation,”it said.

“Uncertainty about wages growth also translates into uncertainty about the outlook for household disposable income, which has a direct bearing on consumption growth, as does the evolution of housing prices through household wealth.

Clearly, wage growth is not only a major source of uncertainty, but also key for the RBA achieving its optimistic forecasts, all but ensuring next weeks Wage Price Index (WPI) will be a blockbuster release.

RBA

Internationally, the RBA nominated the outlook for the Chinese economy as the greatest risks to its projections.

“The risks to global growth from trade protectionism have intensified,” it said.

“In light of this, and the ongoing efforts of Chinese authorities to manage slowing growth without exacerbating financial risks, there is considerable uncertainty about the outlook for China, which is a key trading partner for Australia.”

However, as the bank has pointed out recently, its job is not to focus on potential tail risks but rather the scenario that’s more likely to unfold.

Right now, it’s clearly optimistic about the outlook despite large domestic and international uncertainties that could potentially lead to an adverse economic shock.

For its forecasts to be hit, not only does a lot have to go right, very little can go wrong.

Whether its forecasts are achievable remains up for debate — they are very optimistic — but the signals it’s sending right now indicate it’s edging closer to lifting rates.

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