From Bill Evans:
The Reserve Bank board meets next week on October 6. There is little chance that the Board will decide to change rates.
Markets are giving a less than 10% probability to a move in October rising to a 25% probability by November and 50% by December.
That pricing compares with market pricing, back in late August, of a 100% probability of a December move.
The 100% probability has now been pushed back to February next year with a 40% probability of a second cut by June.
Those daunting probabilities contrast with our current view that rates will remain on hold over the course of 2016.
Assessing the mood of the Reserve Bank is key to predicting the result of the most immediate meeting. It is clear that at the moment the Governor is committed to holding the line.
Beyond that immediate move it comes down to economic forecasting.
The Bank will decide to move on rates if it is forced to adjust its forecasts to a point that without a further policy response growth in the economy will be at a consistently sub trend level. That decision will also be impacted by the realistic assessment that the effectiveness of easing monetary policy has been greatly reduced by the post GFC build up in household debt. However, as we saw earlier this year, reduced effectiveness is no excuse for eschewing monetary policy altogether.
I still recall a response from Deputy Governor Lowe to a question I asked him in a public forum in December 2012 as to how low interest rates could go in Australia – he nominated a cash rate of 1%.
Because growth (and by implication unemployment) forecasts are the key to any policy change decision November/February/ May/ and August become the key policy months because it is at that time that the Bank reviews its forecasts and based on those reviews can put forward a case for its policy decision.
Recall that at the moment the Bank is forecasting growth in 2016 of 3.0% and in 2017 of 3.75%. It has also indicated that trend growth is now likely to be around 2.75% so an above trend outcome for 2016 is an acceptable result and one not requiring any policy response. Indeed it has observed that despite GDP growth of only 2% in the year to June 2015 the unemployment rate appears to have stabilised and its forecast going forward is for ongoing stability in the unemployment rate.
Our own forecast for GDP growth in 2016 is 2.8%, slightly lower than the Bank’s number and likely to be the Bank’s forecast for 2016 when it next produces its forecasts in November. That downward revision is unlikely to be a sufficiently significant move to trigger a policy response particularly when it is likely to only 2 October 2015 shave its 2017 forecast from the “bold” 3.75% to around 3.5% (still well above trend and consistent with a steady fall in the unemployment rate). Our own forecast for 2017 is 3%.
A (no policy change) growth forecast for 2016, at the February board, that would trigger a policy move (an expected 100% probability according to market pricing) would be 2.5% or less. Recall that when the Bank cut rates in February this year it revised down its growth forecast for 2015 from 3% to 2.75% and noted that “informed by a set of forecasts based on an unchanged cash rate”.
That means that if the Bank had not cut rates at all then it would have been forced to forecast an even lower growth rate, presumably 2.25%–2.5%. At the time it assessed that trend growth was 3% so a growth forecast of 2.25%–2.5% (well below trend and implying a rising unemployment rate) when it had 250 basis points to “play with” would have been verging on irresponsible policy. Inflation pressures were under control and it had announced a new macro prudential policy to contain growth in asset prices. Further, the AUD was at USD 78¢ (iron ore price USD 62 per tonne) and the Bank commented “above most estimates of its fundamental value” whereas at USD 0.70¢ (iron ore price of USD 56 per tonne) the Bank is now comfortable with its level.
So the real question is what growth revision for 2016 at the time of the February board meeting would prompt a policy response. As discussed our current forecast is GDP growth of 2.75% in 2016 (up from 2.2% in 2015). That number, if adopted by the Bank in February, is around trend and unlikely to prompt a policy move.
Embedded in our 2.75% forecast are the following sub forecasts:
1. Consumer spending growth in 2016 will lift from 2.3% in 2015 to 3.2% in 2016. That will be largely driven by an expected stable year for commodity prices supporting only a modest fall in the terms of trade (compared to around 10% in 2015) and a lift in nominal GDP growth (and associated income growth) from 2.4% in 2015 to 4% in 2016.
2. Dwelling investment will slow from 10% growth in 2015 to stabilising in 2016, mainly driven by a 4.5% contraction in new dwelling construction.
3. Net exports will add 1.3 percentage points to growth compared to only 0.5 percentage points in 2015. The boost to net services exports from the ongoing competitive AUD and some volume increases in the resources sector are driving that forecast.
4. Growth in non-mining investment will lift from 2% in 2015 to 4% in 2016.
5. Mining investment will contract somewhat more rapidly in 2016.
With that growth profile we expect that the unemployment rate will stabilise around 6.1%. With the Bank likely to continue to expect growth of 3.5% in 2017 that implies its assumption of a likely gradual fall in the unemployment rate through 2017.
We expect that the Bank will adopt a similar view and hold rates steady.
But there are risks which are, not surprisingly, to the downside.
An alternative scenario largely built around ongoing pessimism about the world economy could raise expectations for another sharp fall in commodity prices and the terms of trade slowing nominal income growth to another 2% year leading to an associated 2.3% household expenditure growth and no lift in non-mining investment growth. That would imply overall growth in 2016 of another 2.2% (like 2015) and the need for the Bank to cut rates by a further 50 bp’s (somewhat more aggressive than market pricing).
So the view that rates will remain on hold is heavily dependent on some stability in the global growth outlook.
We are predicting a more stable global environment in 2016. Overall we expect world GDP growth to lift from 3.1% in 2015 to 3.6% in 2016 including US growth at 2.8% and some of the gloom around China to lift particularly as the authorities continue to roll out stimulus. Avoiding a hard landing in China will, in turn, assist emerging markets through stability in commodity prices and a boost to exports as both US and China lift their support.
These are particularly uncertain times. If we were to significantly change our global view we would certainly be more comfortable with the market’s expectation of 1.5–2 rate cuts next year in the six months to June.
We will watch these developments closely over the next few months. If we change our global view to something much more negative then the easing policy response by the RBA beginning in February will be the obvious policy call.
The times are only uncertain if you’re overly bullish. The RBA’s 3.75% call for 2017 is absurd. By then China will be growing at 5% if it manages things well. With this and the US constantly on the verge of tightening, commodity prices are not going to stabilise. The five points of accelerating growth don’t stack up, either:
- Consumers will not spend more. Partly because income will remain under pressure but also because house prices will slow in the East and tumble in the West. Wider volatility will grow as well (and result in crisis in our view but that’s a by the by).
- Dwelling investment will not stabilise but peak and begin to fall as Chinese investment slows and local prices stall and banks tighten on developers, thus detracting from growth.
- Net exports will be good, yes, not least because consumption will be muted.
- Growth in non-mining investment will fall as the ABS data currently predicts, though hopefully not as steeply as it currently suggests.
- Capex cliff, yes.
They’ll have to cut again, Bill. Your outlook is far too rosy. I suspect in your gut you know it, which is why you wrote this piece.
