By Garry Shilson-Josling
The Reserve Bank of Australia has lowered its forecasts for inflation and economic growth, but sees those forecasts as resting on some key assumptions about wages and productivity.
In its quarterly statement on monetary policy, the RBA confirmed that, although Europe's sovereign debt crisis remains the biggest risk to world economy, its interest rate cut on Tuesday was a response to slower economic activity in Australia.
It had earlier flagged the possibility of lower rates, given a benign inflation outlook, if the economy needed a boost.
In the statement, the RBA said that data over the recent couple of months had "suggested that it was appropriate to take a further step in that direction".
It also noted the widening of the gap between bank funding costs and the cash rate, about 20 basis points (0.2 percentage points) since the middle of last year.
That was a clear indication that the bigger-than-normal cut in the cash rate - half a percentage point - was driven by the efforts by the banks to sustain their interest margins than any sense of panic at the RBA over the economy.
The changes to the RBA's forecasts were significant, especially for the short term.
Forecast growth in gross domestic product (GDP) for the year to June 2012 was revised back to 2.75 per cent from the 3.5 per cent forecast only three months earlier.
Underlying inflation for the same period, excluding the slight impact of the carbon prices, is now tipped to be 2.0 per cent rather than 2.25 per cent.
But the inflation outlook rests on the key assumption that labour costs will remain consistent with the forecasts.
This is particularly concerning to the RBA because, now that the Australian dollar has stopped rising, the deflationary effect in the prices of internationally tradable goods and services has also waned.
At the same time, non-tradable prices, driven by domestic economic conditions, are still rising.
"Sustained moderation in domestic cost pressures will therefore be necessary to keep non-tradables inflation continued," the RBA said.
"This is likely to require a further easing in labour costs and other costs, and/or a pick-up in productivity (output per hour worked) growth."
If the pick up in labour productivity flowing from the structural adjustment in the economy took longer than expected, or if that were to be offset by rises in other costs, then activity would be weaker and inflation would be higher than forecast, the RBA said.
The upshot of that is that the RBA will be particularly sensitive to indicators of wage costs and labour productivity as it ponders whether or not to vindicate the strongly held expectations of investors that it will cut the cash rate further in the near future.
AAP