From Bloxo:
* The 50bp of cuts delivered in H1 2015 should support growth, but could also boost a booming housing market
* Authorities are increasingly aware of the risk that very low interest rates could inflate asset price bubbles: as a result, authorities are further tightening the prudential settings
* We expect the RBA to remain on hold in coming months, as it weighs the risk of inflating asset price bubbles against supporting a needed pick-up in real economic activity
Balancing the real economy and financial cycle
The RBA continues to face a tricky trade-off. Low interest rates are needed to support the rebalancing of growth towards the non-mining sectors and encourage the AUD to fall. At the same time, low rates are also stoking a housing price boom in some cities, particularly Sydney (up 40% in three years) and to a lesser degree Melbourne (up 24%).
In response to this challenge, the Australian Prudential Regulation Authority (APRA) has been turning up the dial on lending standards, particularly as growth in lending to housing investors has been running ahead of the 10% target pace. Most of the major banks have reduced discounts on lending rates to housing investors in recent weeks as a result. Of course, this comes at the same time that the RBA has delivered another 25bp cut, on 5 May, so broader financial conditions are looser.
With the APRA more focused on managing the financial cycle, the RBA may be able to increasingly shift the balance of its focus to supporting the real economy. This month brought further signs of rising household demand: dwelling approvals are lifting and this is feeding through to retail sales. However, the capital expenditure survey still shows few signs that non-mining businesses are prepared to ramp up their investment plans, which is the next stage of the rebalancing act. The labour market looked more promising, with hours worked up and the unemployment rate steady. This could be providing the tell-tale signs of an improving business sector outlook, although it is too early to be confident.
The Federal budget, delivered in early May, included measures that were a bit more supportive of growth than last year’s budget and drove a modest increase in consumer sentiment. The AUD has also fallen, as the USD has appreciated, which is helpful for growth, although, on our estimates, it still remains too high for the RBA’s comfort.
We expect the RBA to be on hold in coming months as the central bank watches for the impact on local economic activity of the 50bp of cuts already delivered this year, monitor the impact of the APRA’s tightening measures on the financial cycle, and hopes for a lower AUD.
And Bill Evans:
The Reserve Bank Board meets on June 2 next week. We expect that there is little to no chance that rates will change. Having said that, it is clear that the Bank currently holds a ‘soft easing bias’. We make that assessment for two reasons:
1. In the minutes to the May Board meeting, the Board clarified the lack of guidance in the Governor’s statement by firstly explaining that it was consistent with usual practise following a decision to move, and secondly asserting that members did not see this lack of guidance as “limiting the Board’s scope for any action that might be appropriate at future meetings”. The decision to clarify that position indicates a firm intention to signal an easing stance to the market.
2. The inflation forecasts in the Statement on Monetary Policy (released May 8) included the view that underlying inflation would be in the bottom half of the target band in 2016. This is the only time, aside from during the depths of the GFC, that the Bank has forecast inflation in the medium term to be below the mid-point of the target band.
Our assessment of the Bank’s current thinking hinges around three issues:
1. Because growth in 2015 is expected to be below trend at 2.5%, the unemployment rate will gradually edge up through the year. If the unemployment rate stabilises at its current level (6.2%), that might motivate the Bank to review its thinking that below trend growth typically leads to rising unemployment. For example, stronger demand for labour may occur due to very weak wages growth.
2. While economic growth is forecast to be below trend in 2015, the Bank expects growth to lift to around trend (3.25%) in 2016. That lift would stabilise the unemployment rate, precluding the need for further stimulus.
3. Non-mining investment will eventually respond to household demand. Evidence of a sustained lift in household demand should in time boost non-mining investment as businesses become more confident that stronger sales can be sustained.
4. The Australian dollar is currently overvalued and not only will fall but needs to fall. With that framework in mind, a number of policy options are possible.
For instance, even if demand softens through 2015 to the point where growth in 2016 is likely to once again fall below trend, stability in the unemployment rate in 2015 would lessen any need to provide further stimulus, even with the prospect of another year of below trend growth.
Our own view on the outlook for the unemployment rate is in line with the Bank’s current forecast. Although there still appear to be survey problems affecting the official labour force estimates month to month, the data is showing some improvement, with employment growth running at 1.6%yr.
The Westpac Jobs Index – our composite based on the labour market measures from private sector business surveys – suggests this modest positive momentum is holding. However, that is still slower than current growth in the working age population. As such, assuming no change in participation rates, the unemployment rate is still expected to move higher, reaching an eventual peak of 6.5%.
As indicated, prospects for growth in 2016 will be heavily influenced by trends in household expenditure in 2015. Westpac currently expects household expenditure growth in 2015 to be consistent with 3% GDP growth in 2016. Although still not strong, spending growth has already picked up from 1.7%yr in 2013 to 2.5%yr in 2014 in year average terms. While the 0.9%qtr gain in Q4 looks to be overstating the strength of that pick-up, the 0.7%qtr gain in Q1 real retail sales suggests demand has sustained reasonable momentum into 2015. With rate cuts and the Budget giving a lift to confidence and disposable incomes, momentum should carry into Q2.
The sharp deterioration in the outlook for non-mining investment as indicated by the March quarter capital expenditure survey is a disturbing development. However, it is likely that time will be needed to assess whether these prospects improve in light of encouraging signals around household expenditure. There are clearly still risks. A continued improvement in sentiment and a stabilising labour market in particular are required to ensure a further lift in demand later in the year.
However, on balance we expect spending growth to show a modest lift this year to 2.7%yr, and to 2.9% in 2016.
Finally, the prospects for the Australian dollar will be impacted by its current over–valuation relative to commodity prices. Our fair value model currently sits at around USD0.72. That is unlikely to change as we expect key commodity prices will remain fairly flat over the rest of this year.
One of our key themes however is that US dollar strength can be expected to re-emerge over the remainder of the year. In particular, recent inflation and partial activity data in the US along with consistent ‘Fedspeak’ give us reasonable confidence in our long held view that the Fed will begin tightening rates in September with a follow up move in December – a swifter profile than currently anticipated by the markets.
We expect that such developments will see the AUD moving in the RBA’s desired direction. Current market pricing for RBA policy gives around a 60% probability of one rate cut by the December quarter. Under our preferred scenario (rising unemployment rate in 2015; 3% GDP growth in 2016; AUD back to USD0.73 by end 2015) policy is likely to remain on hold.
However, we support the view implied in the RBA’s bias that the risks to rates remain to the downside. In particular, any slippage in household expenditure growth which would dampen prospects for a recovery in non-mining investment would affect growth forecasts for 2016 and substantially increase the risk of lower rates.
However, we expect that the timing would be later than current market thinking (first move in November at the earliest) and the extent of the cuts would be a total of 50bps rather than the market’s current 25bp expectation.
Phew, ain’t that sunshine lovely!
