Westpac’s Bill Evans cut from the pack back in July to forecast year end rate cuts. He was ridiculed at the time by many, including some especially infantile drivel from the bullhawks. Well, after today’s RBA meeting he’s looking awfully good. And today issued a note reaffirming his stance:
Westpac Economic update
As expected Reserve Bank holds rates steady, but adopts an easing bias
As expected, the Reserve Bank Board decided to leave rates unchanged at 4.75% at its October meeting.
However it is our assessment that the Board has now adopted an easing bias. This is in sharp contrast to discussing the possibility of raising rates as recently as the August Board meeting. The key to the easing bias has been an improved outlook for inflation partly as a result of the downward revision to the June quarter measure of underlying inflation and partly due to evidence of softening demand. The key sentence in the statement is “an improved inflation outlook would increase the scope for monetary policy to provide some support to demand, should that prove necessary.”
That does not mean that the Bank is committing to a rate cut at its next meeting in November. However, it does indicate that the inclination is now towards cutting rates. Our view is that typically central banks do not raise the prospect of lower rates without a strong body of evidence to support a cut. That key sentence however is not as strong as we saw in August 2008 when the beginning of the 2008/09 rate cut cycle was signalled with “On these considerations, a case could be made for an early reduction in the cash rate.” Accordingly, rates were cut by 25bps at its September meeting which predated the Lehman Brothers collapse.
The overall commentary in the statement did not indicate to us that an easing bias was eventually going to be adopted near the end.
Economic conditions were described as soft in both Europe and the United States and the overall commentary on the Europe/US situation was not particularly more down-beat than in September.
We were surprised that the recent turmoil in Asian financial markets was not given more consideration with the theme which we saw in September being retained, i.e. “It will take more time for evidence of any effects of the recent European and US financial turbulence on economic activity in other regions to emerge.”
On the domestic front, the observation made in September that the near term economic outlook was not as strong as earlier expected was retained but in contrast with the September statement, where the medium term outlook was expected to be at trend or higher no commentary was given on the medium term this time. The commentary on inflation was significantly more confident than in September. This would partly reflect the downward revision by the ABS of the underlying measure for the June quarter from 0.9% to 0.6%. The Board is now entertaining the view that the weaker economic conditions are likely to contain inflation pressures with the path for inflation now being more consistent with the 2-3% range for 2012 and 2013. The September quarter inflation print which will be released on October 26 is now assessed as being very important for the inflation outlook and the policy decision.
Other domestic data was generally softer with labour market conditions being described as “now a little softer” and the Westpac-Melbourne Institute Index of Unemployment Expectations getting some indirect recognition with “households more concerned about the possibility of unemployment rising.” Financial conditions are described as easing somewhat due to slightly lower fixed interest rates which are, ironically, possible due to the market predicting rate cuts, and of course the recent fall in the exchange rate. However, it is still recognised that credit growth is low and asset prices have declined.
Conclusion
Back on July 15 Westpac predicted a 25bp rate cut by December 2011. That was despite all other economic forecasters which contribute to the Bloomberg poll predicting rate hikes. The evidence from today’s statement is that a cut as early as November is very much on the cards although a low read on inflation, which is Westpac’s forecast, will not necessarily lock the Bank into a cut in November given its emphasis on demand conditions. With that in mind we are content to retain our December call whilst recognising that the chances of November have increased substantially.
Meanwhile, those bank economists that aligned themselves with the bullhawkian view find themslves twisted in knots dodging the reality closing in their forecasts. For Paul Bloxham at HSBC, who has maintained the next move will be up all year, it’s not that he got it wrong, rather it’s the RBA being dragged kicking and screaming from his forecast:
RBA Observer Update
The art of doing nothingHolding rates steady today means the Governor has now clocked up 11 months of policy rate stasis. This is far from unusual though; with the former Governor holding rates steady for 12, 14 and 16 months. The RBA is quite happy to sit still. The tone of the post-board statement suggested that they have an open mind about the next move, but that any moves are highly dependent on the inflation outlook. The focus now shifts to the Q3 CPI numbers, published on 26 October. If you believe, as we do, that underlying inflation will print high, they will be hard pressed to change direction as markets are pricing.
Facts
– Cash rate was held steady at 4.75%, for the eleventh month. This is the longest pause in over five years. Long periods of steady rates are not unusual for the RBA: in the past decade they have held steady for 16 months, from June 2002 to October 2003, 14 months, from December 2003 to February 2005 and 12 months, from March 2005 to April 2006.– The statement suggested that ‘it will take more time for evidence of any effects of the recent European and US financial turbulence on economic activity in other regions to emerge. Thus far, indications are that economic activity is continuing to expand in China and most of Asia.’
– It also suggested that ‘an improved inflation outlook would increase the scope for monetary policy to provide some support to demand, should that prove necessary.’
– And that ‘with labour market conditions now a little softer … the likelihood of a significant acceleration in labour costs … is lessening.
– Data published today for August showed a strong rise in medium density building approvals (total building approvals +11%) and a strong bounce back in coal exports (total exports +8%). This reminds us that Australia still has some bounce back from the effects of the Queensland floods to flow through the economy.
Implications
The Governor has told us previously that in times of financial volatility, he likes to ‘sit still’ if he can. And, once again, that’s what we saw happen today.But while this is the longest period of steady rates for the current Governor it is not unusual for the RBA to sit still for a long time. The previous Governor had long stretches of policy stasis.
Suffice to say, the RBA does not tend to finetune. Steady policy is preferred. With this in mind, we think the RBA is still very keen not to have to cut rates, if it can avoid it, given the medium term outlook for the mining investment boom, the very high terms of trade and the limited supply capacity of the economy.
Nonetheless, if things get bad enough in the global economy, their hand may be forced. There was more recognition of this possibility in today’s statement than previously.
Indeed, markets have interpreted today’s statement as dovish.
We agree that it was clearly more dovish than previous statements, though we would still characterise it as fairly neutral overall, for two keys reasons.
First, they pointed out that it is too early to tell what the financial market turmoil means for Australia and indeed for Asia. The statement specifically suggested that, ‘thus far, indications are that economic activity is continuing to expand in China and most of Asia.’
Second, the RBA have, as always, made any ‘support to demand’ from monetary policy (that is, rate cuts) highly contingent on the inflation outlook.
As we have pointed out repetitively, to cut rates the RBA would need to be able to credibly revise down its underlying inflation forecasts from above the target band down to the lower half of the target band. This is a long way to move given the very strong pick up in mining investment, weak supply side of the economy and general global inflationary environment. Add to this that the exchange rate is now giving them less help.
All this makes the Q3 CPI, which is published on 26 October, all the more important. If it prints high they will be hard pressed to change direction, as markets are pricing.
Bottom line
We still expect the RBA to be on hold for the rest of this year.While the medium-term outlook for rates is more uncertain than usual, as it very much depends on the global outlook, we still think the next move will be up, rather than down, due to inflation risks.
The NAB also had rate hikes priced in all year and now finds itself flipping:
The RBA left the cash rate on hold again at 4.75% as they have done after having last hiked in November 2010.
It’s pretty clear that the RBA Board is much less anxious about the potential for inflation becoming a policy headache and are growing more concerned about slowing growth at home and abroad. At the September Board meeting, they talked about the potential for softer global and domestic economic growth to contain inflation. This month they added to that the recent downward revision to underlying inflation and that “with labour market conditions now a little softer and households more concerned about the possibility of unemployment rising, the likelihood of a significant acceleration in labour costs outside the resources and related sectors is lessening”.
If the next CPI proves to be benign this would see them cutting their
inflation forecasts. And “an improved inflation outlook would increase
the scope for monetary policy to provide some support to demand, should that prove necessary”. This implies that the RBA now sees the risks as clearly pointed to the downside.Like everyone they are watching international events closely and through the elevated market volatility they note that forecasters have lowered their forecasts and now expect average world growth; they also note that recent data points to a continuing period of soft growth in Europe and the US.
The RBA has lowered their sights on the Australian economy; they expect the near-term outlook for growth is “now a little softer than earlier expected”
though over the medium term they expect good growthWithout saying naturally what they might do at upcoming meetings, they are setting the scene for either steady or lower rates in the months ahead.
They are not yet at the point of easing – they would have done it already – but are watching the data closely. Their outlook for inflation will be “reviewed” “on receipt of further data on prices ahead of the Board’s next meeting”. This makes the October 26 CPI that much more important in their policy evaluation. New forecasts will be released on Friday 4 November in the Monetary Policy Statement and available for the November Board meeting.Our outlook for the cash rate has been for steady rates for some months ahead but we’d be the first to recognise that should the international economy continue to decay and the domestic scene soften further, the RBA is prepared to pull the pin and cut “should that prove necessary”. The focus is now on the downside risks. Those risks could come from a sharp deterioration in domestic conditions (another significant rise in unemployment or a substantial drop in NAB Business Conditions), or from offshore (Chinese growth most critical, and a further big drop in commodity prices could signal that; or a banking meltdown).
On hold for now with the door opening for a cut and we, like the RBA, will continue to monitor the economy (including risks) relative to our baseline growth and inflation forecasts.
As did ANZ, also flipping:
RBA OPENS THE DOOR TO EASE
The RBA kept its cash rate unchanged at 4.75% at today’s October Board meeting.
Today’s Statement however presents a clear shift of tone. The RBA has opened the door for a modest easing of policy, lowering both its short-term growth and 2012-13 inflation forecasts for Australia. A 25bps interest rate cut in November, followed by another 25bps of easing in February, now looks increasingly likely. This will be contingent on a modest core inflation outcome for Q3. ANZ is forecasting core inflation to rise 0.6% in Q3, opening the way for a rate cut in November.
The RBA now expects inflation (ex-carbon tax) to be “more consistent” with its 2-3% target. This downward revision reflects both a lower starting point for inflation (after the ABS’s downwards revisions to seasonally adjusted underlying inflation) as well as the recent softening in labour market conditions, which have left the RBA less concerned about wage pressures spilling outside of the resources sector.
These forecast downgrades, according to the RBA, now give scope for monetary policy to “provide some support to demand” should that prove necessary. In other words, the RBA is not yet over the line for an easing in policy, but will be prepared to cut rates should the outlook deteriorate further. A November rate cut could be viewed as insurance against the global financial disruptions having a bigger effect on economic activity in 2012 than currently anticipated.
The other concern that is emerging is the rising cost of funding across the global financial system, particularly for banks. Australian banks, whilst less reliant on global capital markets than in 2008, are not immune from these trends. A sustained rise in bank funding costs over the next three to six months will ultimate raise funding costs for all businesses across the economy. The RBA may wish to offset some of these pressures with interest rate reductions. That the RBA is not yet convinced of the need to ease policy reflects:
– The RBA’s still strong medium-term outlook for the Australian economy (at a time when inflation has troughed).
– The judgement that it is still too early to tell how big the impact will be to the global and local economy from current financial market volatility.
– And, potentially, the Board’s judgement that financial conditions in Australia have actually already eased, due to lower interest rates for housing and business loans, falling funding costs and the sharp fall in the A$. So, what will it take to push the RBA over the line and ease? We expect we will need to see:
– Confirmation that inflation is under control. This should occur on the 26th of October with Q3 inflation expected to print modestly (ANZ preliminary forecast is +0.6% for underlying inflation).
– Further evidence that the labour market has softened. Next week’s labour market data remains a wildcard, but the recent sustained softening in ANZ job ads, at the very least, suggests any bounce in employment next week would most likely be an aberration.
– A further deterioration in global conditions, and in particular further corrections in equity markets and commodity prices, and a further widening in corporate credit spreads. Indeed, the credit channel remains the biggest source of risk to the Australian economy from current global events. A consideration of these factors suggests that the preconditions for easing could all be fulfilled as early as the next Board meeting in November.
At this stage, we expect the RBA’s strategy will be to take monetary policy back to neutral. Notwithstanding any pass-through of potentially higher bank funding costs, this would involve around 25 to 50bps of cuts to the cash rate. Without a further very sharp deterioration in global conditions, we see little chance that the RBA will embark on the substantial policy easing currently priced into the OIS market (more than 160bps of cuts, taking the cash rate to near its GFC low of 3.0% by next year). Moreover, should China and Australian export commodity prices escape most of the severity of current global risks, and thus Australia’s enormous investment pipeline remain on track, we think it is highly likely that the RBA will look to remove this policy easing, and return local rates to a mildly restrictive setting by mid-2013. But there is also the risk of a more severe global downturn in the meantime that could force more substantial cuts from the RBA in 2012. As such, we have left the cash rate at 4.25% over the forecast horizon.
CBA was one the most aggressive, and it’s silent so far this afternoon.
So, how did Bill Evans trump everyone so comprehensively? Simple, he played the ball, not the man. He watched the economy, not the RBA. Just as we did here at MB.
