From Bill Evans:
This week, RBA Governor Stevens gave an important speech to the Economics community.
This annual speech, the Anika Foundation Luncheon, is the only event that he has spoken at every year since his first appointment as Governor in 2006.
The market takes this speech very seriously and there are usually important insights into the Governor’s thinking.
This year there was one really big surprise.
He was prepared to tackle the surprise observation that, despite growth of only around 2.50%, the unemployment rate appears to have stabilised. Standard RBA thinking has been that growth needs to be around trend to stabilise the unemployment rate, and trend or “average” has been assessed as 3.00–3.25%.
This “average” concept always appeared to be somewhat curious given that it covered both pre and post GFC periods. It has generally been accepted that due to the sharp build up in debt in the developed economies, the headwinds associated with that debt have constrained growth. Adopting averages over longer periods seemed to overlook that particular observation.
Nevertheless, the Bank’s approach has been to expect trend or “average” growth to be around 3.00–3.25%.
The Governor gave a number of potential explanations as to why unemployment seems to have stabilised at growth of only 2.5%: noise in the labour force data (including the need for revisions); actual GDP growth will be revised higher; slower wages growth has lifted the demand for labour given a particular level of overall demand growth (of course that does overlook the fact that the LEVEL of Australian wages and the structure of the awards system is still very high by international standards); and most importantly “perhaps trend output growth is lower than the 3.00–3.25% that we have assumed for many years”.
(There will continue to be a close focus and analysis of labour market data over coming months. If, for instance, the unemployment rate begins another upward leg, this would cast a new light on this debate around trend growth.)
Stevens then mused, “To the extent that our assumptions about trend growth may need to be revisited, that will be worth some discussion…. If there are assumptions about absolute growth rates embedded in business or fiscal strategies, or retirement income plans, they would need to be re-examined”.
Consider the importance of these deliberations for monetary policy.
In early December last year, Westpac changed its rate outlook from “steady” to forecasting two more cuts in early 2015. That 24 July 2015 was despite the Governor having just noted in his Statement earlier in the week that the prudent interest rate policy would be “a period of stability”.
The reason for our decision to call rate cuts was that the September quarter national accounts that printed the day after the December RBA board meeting indicated that the economy was losing momentum through the second half of 2014, and it was therefore highly unlikely that the Bank’s forecast that growth would lift from 2.50% to 3.00% (i.e. trend) in 2015 would prove to be correct.
Of course, the significance of the 3.00% forecast is that the Bank was anticipating that growth would return to trend in 2015 and the unemployment rate would begin to stabilise.
Further, the forecast growth rate for 2016 of 3.50%, half a per cent above trend, would ensure a steady fall in the unemployment rate over the second half of the forecast horizon.
It became clear to us that, when the Bank provided its next set of forecasts in February, it would be forced to lower the 2015 forecast to around 2.50% – below trend – implying that it expected another year of rising unemployment. Furthermore it was unlikely that it would be able to credibly retain the 3.50% forecast for 2016, implying yet another year when the unemployment rate would be stuck above an unacceptably high 6.00%.
In the event, the Bank did cut rates by 25bps in February this year, and revised down its growth forecast for 2015, from 3.00% to 2.75%, despite assuming a second rate cut of 25bps (by adopting “market pricing” for the rate forecast that was used to derive its new growth forecasts). Because of the rate cuts, it decided to retain the forecast for 2016 at 3.50% – above trend and consistent with a falling unemployment rate in 2016.
In May, the Bank cut by a further 25bps, but revised down its growth rates further, to 2.50% in 2015 and 3.25% in 2016 (the May cut was already factored into the February forecasts).
Since May, momentum in consumer spending has disappointed. For example, we assess the Bank would have been expecting to see the annualised pace of consumer spending lift from 2.50% to 3.00%, but the March quarter national accounts dashed that prospect. The most recent capital expenditure survey highlighted further disappointment for the investment outlook – both for mining and non-mining.
The Bank has also hardly been enthused by the recent momentum from the consumer, “Year-ended growth in retail sales had been little changed over recent months and liaison suggested that this was likely to have continued into June”. (July Board Minutes). 2 Past performance is not a reliable indicator of future performance. The forecasts given above are predictive in character. Whilst every effort has been taken to ensure that the assumptions on which the forecasts are based are reasonable, the forecasts may be affected by incorrect assumptions or by known or unknown risks and uncertainties. The results ultimately achieved may differ substantially from these forecasts.
For those reasons, it is possible that the Bank will decide to lower its forecast for growth in 2016 further from 3.25% to 3.00%. That number is still at “trend” and, as with 2015, would not represent a case for a need to further cut rates. But the downward drift of the 2016 growth forecasts would certainly raise a few eyebrows.
Under the “old” assumption of trend/average at 3.00–3.25%, the new growth forecast would be coming treacherously close to yet another year of forecast below trend growth. With the unemployment rate stuck above 6%, there would be a respectable case for the need for the Bank to cut further.
For example, if the data momentum pointed to a further downgrade in the 2016 growth outlook by the November forecast round, the case for a November cut would be clear.
But the Governor has now raised the case (as clear as you can expect from cautious central bankers) that “trend” growth may be lower.
If, for example, the Bank revises its assessment of trend growth to 2.75%, then it is highly unlikely that it would see a case for below trend growth in its 2016 November growth forecast, virtually eliminating the case for lower rates in November.
We say, virtually, because the Bank could take another tack by asserting that its growth forecasts, while lower, were still consistent with stabilising and eventually falling unemployment. But, equally, a reasonable person could argue that a 6.00% unemployment rate still signals considerable spare capacity in the labour market and any central bank with scope for further stimulus should not be satisfied with a growth forecast that only implies a very slow easing in the unemployment rate.
From our perspective, the most likely policy scenario is that the Bank will have to lower its 2016 growth forecast through the August/November forecasting rounds, but because it now has both quantitative and qualitative evidence that, like other developed economies, trend growth has taken a step down since the GFC, it can still argue that growth in 2016 will be above or at trend, hence no policy response will be required.
An impressive argument. But it fails on one count. It is too busy looking at Glenn Stevens and not the economy. The terms of trade crash is only a little more than half over. The first half of that has taken rates down by 2.75% to 2%. The second half will take it down another 1% at least.
This is what the falling dollar is starting to discount.
