Banks on rate effects

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Following are some bank economist’s takes on the RBA’s decision to cut today. They are all quite subdued.

First, Macquarie Bank sees a limited effect on consumer disleveraging:

The Reserve Bank of Australia (RBA) decided to cut interest rates by 25bps at its December Board meeting. While markets were almost fully priced for a rate cut, analysts were evenly divided as to whether the RBA would follow up its November easing with another rate cut in December. We thought a rate cut became likely following the decision of the Chinese authorities to ease monetary policy and the co-ordinated policy actions of the 6 central banks last week, as this highlighted that the global growth outlook had continued to deteriorate.

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Consistent with that, our China economist Paul Cavey expects further weakness in Chinese manufacturing in coming months and thinks the risk of Chinese growth temporarily slipping below 8% has increased. And, indeed, the RBA does imply that it is the slower global growth outlook and the impact on commodity prices — and hence inflation — that was one of the key reasons for easing policy again.  The RBA cites slowing growth in China, the impact of weaker European growth on Asian trade, as well as the impact of financial market volatility stemming from the European debt crisis as the key reasons to think that global growth will be much weaker.

The RBA is certainly not exhibiting any signs of panic about the domestic economic outlook yet. Certainly, it seems more convinced that the moderation in consumer spending may be more sustained and is more cognisant of the impact of the strong $A. But overall it doesn’t seem too unhappy with the current pace of activity. What has clearly changed is that the slight weakness of the labour market which — together with the moderation in commodity prices — means that the RBA is much more comfortable with the inflation outlook. And this was reflected in the RBA’s conclusion that it was “the inflation outlook (that) afforded scope for a modest reduction in the cash rate.”

Implications for the interest rate outlook

What does this decision mean for the possibility of future rate cuts? The RBA doesn’t provide any encouragement for the view that it is poised to embark on an aggressive easing of policy from here. That said, the statement clearly highlights where the RBA’s sensitivities are. First, further confirmation of slower global growth and commodity prices. Second, further weakness in the labour market. And third, better inflation news.

In that respect, a key factor to watch will be the next inflation reading which will be released at the end of January, just ahead of the next scheduled RBA policy meeting on 7 February. Partial indicators suggest that this will again be very benign — at present we are looking for a ¼ppt reading for underlying inflation. This would likely prompt the RBA to again revise down its inflation profile for 2012 which certainly opens the door for further rate cuts at that time.

We are also more cautious about the outlook for unemployment and expect it to rise to 6% by mid 2012. And clearly the risks surrounding global growth are also heavily skewed to the downside. Thus, the conditions for further rate cuts are clearly there.

Thus, while the RBA hasn’t pre-committed itself to cutting rates further, if we do get a further deterioration in unemployment, low inflation and/or further downgrades to the global growth outlook, the RBA will not hesitate to respond. On that basis, we still anticipate that the RBA will cut rates at its next Board meeting in February 2012, as well as the May Board meeting.

How will it affect the economy?

In our view, the December rate cut will offset some of the downside risks to growth in 2012, but is not yet the signal for a rapid turnaround in activity. First, note that monetary policy is only now back at a neutral setting. That is, the brake on growth has been released, but the new setting of interest rates won’t yet be stimulating activity. And when the high level of the currency is taken into account, together with the weakness of financial markets and tight fiscal policy, it is clear that the domestic economy is still facing considerable headwinds.

Second, we also think the background environment is crucial in determining how monetary policy will affect the economy. When household borrowing is strong and asset prices are rising sharply, a reduction in interest rates will encourage households to access the unrealised capital gains in their property by gearing up further. At the same time, if household wealth is rising sharply, households will be more likely to boost consumer spending and run down savings. Furthermore, property investors are likely to see falling interest rates as the green light to increase their exposure to the housing market.

Clearly that is not the environment facing the economy at present. Assuming that the interest rate cut is fully passed on by the banks, we suspect that some potential property investors will be deterred from entering the market because of falling house prices. At the same time, those households with an existing mortgage may be more likely to maintain their current monthly mortgage repayments and simply use the interest rate cut to repay the mortgage more quickly, rather than boost spending. Similarly, in the world of falling house prices, fewer people will attempt (or be able) to withdraw equity from their home to fund additional spending.

That said, there will clearly be some benefits from the interest rate cut. First, some potential first-home buyers who have been prevented from buying a property will now enter the market as affordability improves. At the same time, those households which have been struggling to meet their monthly mortgage repayment will find some relief which will prevent a possible cutback in consumer spending that might have otherwise occurred. And potentially just as important is that the RBA’s decision to ease monetary policy again will take some pressure off the A$ which might otherwise have risen strongly over the next couple of months.

The bottom line, however, is that the RBA’s current easing of monetary policy may have a smaller impact than similar easings have had in the past. Thus, we expect to see a slow improvement in activity over 2012, as increased housing finance flows through to increased housing construction, firmer employment and finally some increased spending. But that outlook is also predicated on the RBA easing policy further. If the RBA is content to leave monetary policy at a neutral setting and indicates a strong reluctance to cut rates further, then there is little reason to expect consumers to relax their current caution let alone return to their previously profligate ways.

Westpac sees more cuts in April and May:

The Reserve Bank Board has decided to lower the overnight cash rate by 25bps to 4.25%. This is in line with Westpac’s expectations and the key reasons behind the move were also consistent with our observations. The statement by the Governor had many similarities with the statement on November 1 when he outlined the reasons for the decision to cut rates from 4.75% to 4.50%. This covered issues such as: China’s growth slowing as intended; a moderation in the pace of global growth; Australia’s growth around average levels; strong investment in the mining sector; cautious behaviour by households; unemployment close to 5%; wage pressures easing; and of course inflation likely to be consistent with the 2 to 3% target in 2012 and 2013.

The big differences have come with regard to the global developments, specifically around Europe. Whereas in November the Governor referred to European Governments “making progress” he now talks about “still seeking to craft a full response”. He also introduces the important dimension of financing conditions referring to them being “much more difficult” and indeed does not only refer to European entities but also talks about for Australia “term funding conditions have become more difficult”. He concludes that there is now “the likelihood of a further material slowing in global growth has increased”. We also see specific recognition of the reversal in commodity prices which not only reflects weaker global but also takes some further pressure off inflation.

There is no real change in the assessment on Australia where growth is described as “close to trend”. The concluding paragraph points out that prior to today’s move that lending rates are around their average level of the past 15 years. That is one way in which the Bank has discussed a neutral policy stance in the past although it does not specifically refer to the term ‘neutral’ in this statement. We believe that the neutral level of rates is likely to be lower than the 15 year average due to the much higher debt levels now in the household sector. Most importantly we have seen confirmation of the sentiment that first appeared in the November statement where the objective of policy was seen not only to maintain an acceptable inflation rate but also to achieve sustainable growth.

The outlook
In July Westpac forecast that the easing cycle would cover 100bps with the last rate cut being around the middle of 2012. We are comfortable maintaining that view and see nothing in this statement to suggest that the Bank rules out any further adjustments.

Indeed we do not expect to see developments, either global or domestic, over the course of the next three months that would allay the concerns which have clearly motivated the Bank’s recent two decisions. We would expect the next move to be February being a 25bp cut to be followed a further reduction in May.

CBA sees one more cut:

Some revisions to the inflation profile – history and forecast – opened the door for rate cuts. And the downside risks posed by European developments saw the RBA deliver cuts in November and December. The cash rate now stands 50bpts lower than the recent peak at 4¼%.

The general perception is that recent RBA rate decisions have been close calls. The case for a rate rise was discussed in August – but rates were left unchanged. The case for no change was discussed in November – but rates were cut. And there is a flavour of that in today’s decision as well. Commentary about domestic economic conditions is positive with output growth seen as “close to trend” and demand growth “stronger than that”.

There was no particular rates “guidance” in today’s Statement (which was largely a carbon copy of last month). There is a hint that policy makers have revised down global growth expectations again and a hint of greater concern about financial contagion flowing through to Australian markets. Recurring themes are the idea that household sentiment has shifted in a way that favours less wage inflation and asset prices have shifted in a way that favours household caution. The former theme is part of the case for lower rates and the latter highlights the “insurance” aspect of the rate cuts.

Policy makers are caught between a domestic economy that is in reasonable shape and the risks posed by any European financial meltdown and recession. The balance of these risks argued for a shift away from the slightly restrictive policy settings of earlier in 2011. A range of approaches suggest that a cash rate of 4½% is “neutral” in the current environment. So at 4¼% we now have slightly accommodative policy settings.

QIII GDP data to be released tomorrow should show an economy travelling at an annualised pace of 4% over the past six months, a significant improvement on the flat outcome recorded over the previous six months. So further rate moves will depend on how the European story evolves. While that story is evolving every RBA meeting should be regarded as “live”.

The GDP data will also confirm that the terms‑of‑trade hit a 140‑year high in QIII and that the mining capex boom rolls on. The accompanying stimulus is hitting an economy that on some measures is close to full capacity. Inflation may be a non‑issue in the near term. But upside inflation risks remain over the medium term. RBA forecasts showing underlying inflation picking up into the upper half of the 2‑3% target range at the end of 2013 reflect these risks and argue against aggressive rate cuts.

The other domestic issue relates to the household sector. The national accounts should show that households are a bit more focused on savings and paying off debt and a bit more cautious about spending. Policy makers have spent a fair amount of time getting households to this point to make room for the mining boom to roll through. They are unlikely to want to jeopardise these changes by overstimulating the household sector.

For these reasons we expect only limited action from here. We have a 25bpt cut to 4% pencilled in for February.

A genuine European implosion would, of course, outweigh these domestic considerations in the policy debate. And the monetary authorities would no doubt push rates quickly into more stimulatory territory.

So does NAB:

The RBA today lowered the official cash rate 25bps to 4.25%.

The statement says that the sovereign credit and banking problems in Europe means that the likelihood of a material slowing in global growth has increased. Trade in Asia is now being affected by the events in Europe and commodity prices have fallen, though they remain high.

Domestically, the economy has been growing close to trend, with resource sector growth strong, but credit growth is subdued, asset prices have declined further, the AUD remains high and labour market conditions are softer. The risk of high wages growth outside the mining sector has lessened. Term funding conditions for financial institutions have become more difficult.

Importantly, the RBA reiterated that the inflation outlook is likely to be consistent with the RBA’s 2-3% target range ahead.

Against this backdrop, the RBA decide to cut the cash rate from 4.5% to 4.25%.

Will this be the end of it? We think not.

The RBA is not signalling that a sequence of cuts is likely from here. It says that the Board decided the “inflation outlook afforded scope for a modest reduction in the cash rate” (emphasis added).

However, it seems likely to us that by the next Board meeting, the outlook for global growth will be worse and we expect the next inflation outcome, due in late January, to be another low reading.

The directional bias for rates from here will be down for the next two or three quarters. Hence, there is scope for another cut in rates to 4% at the February meeting.

Today, we will adjust our forecasts to show another 25bps cut in February.

This call is data and event dependent.

The cut may be delayed for a month or two if the local economy continues to hold up. Or it might not happen at all. On the other hand, a meltdown in Europe could see an out-of-cycle emergency cut in December or January.

Still, the prospect of a 3% cash rate by mid-year, as the market is pricing, seems to extreme. Another global recession of the same magnitude of the post-GFC event cannot be the central case.

About the author
David Llewellyn-Smith is Chief Strategist at the MB Fund and MB Super. David is the founding publisher and editor of MacroBusiness and was the founding publisher and global economy editor of The Diplomat, the Asia Pacific’s leading geo-politics and economics portal. He is also a former gold trader and economic commentator at The Sydney Morning Herald, The Age, the ABC and Business Spectator. He is the co-author of The Great Crash of 2008 with Ross Garnaut and was the editor of the second Garnaut Climate Change Review.