From my favourite bank economist:
The Reserve Bank Board meets next week on July 3. We had expected the Board to decide to cut rates by 25bps. However, the contents of the Minutes for the June Board meeting make it clear that a cut in July is unlikely. Despite what we considered to be a sound case to cut rates on domestic grounds in June the Board did not agree. The Minutes revealed that the decision to cut was “finally balanced”, and “recent domestic data had not suggested a significant weakening in conditions compared with forecasts a month earlier”.
The justification for the decision was entirely around “clear evidence suggesting a softening in global conditions”. Members of the Board concluded that there “was scope for monetary policy to be a little more supportive of domestic activity”.
Prior to the June meeting we assessed the neutral overnight cash rate to be 4%, 25bps above the official cash rate at the time of 3.75%. That is, policy was only mildly stimulatory. With the recent cut of the cash rate to 3.5% and neutral following slightly to 3.95%, the policy stance at 45bps below neutral is still only slightly in the stimulatory zone – described by the Board as “a measure of stimulus”.
When the overnight cash rate bottomed out at 3% in 2009 it was around 150bps below neutral. Furthermore, that was a time when fiscal policy was extremely stimulatory (a cumulative stimulus of 6% of GDP in 2008/9 – 2009/10 and the Australian dollar was around USD0.80.
In clear contrast, today fiscal policy is now contractionary (the RBA estimates that the 2012 Budget is likely to subtract something between ¾ to 1 ½ percent from growth in real GDP) and the Australian dollar is above parity at a time when the terms of trade are declining. Financial conditions could hardly be described as stimulatory.
Since the last Board meeting the GDP report for the March quarter printed growth of 1.3% (4.3% annual). That annual number is exaggerated by base effects. The quarterly number was largely driven by consumer spending (up 1.6%) and, predictably, mining investment, which added 0.9ppts and 1.1ppts respectively to growth. Other components were quite weak with residential investment, equipment investment, commercial building, exports and hours worked all contracting.
The surge in consumer spending was associated with a flat price deflator, including falls in food prices that implied a sharp increase in real food consumption – perhaps Australians are becoming a nation of comfort eaters! We suspect there are instead some measurement issues with the estimate.
With the participation rate returning to a more normal level the unemployment rate rose from 5.0% (revised up from 4.9%) to 5.1%. It is hardly surprising that the May report registered jobs growth of nearly 40,000 when the workforce was estimated to have increased by 61,000 in the month. The Westpac-MI unemployment expectations index deteriorated by 3.2% in June with the index now up 11.8% from the start of the year, indicating worsening household fears of a substantial rise in unemployment over the next 12 months.
Since the last Board meeting we have seen weak reads on both business and consumer confidence, with global uncertainty conspiring to unnerve businesses in particular. Recall that the Minutes linked the international story to a potential intensification of precautionary behaviour. Recent business surveys (Q2 Westpac-ACCI and the May NAB) have depicted a material reduction in business confidence.
Evidence of the weakness in the interest rate sensitive parts of the economy was apparent with the reported 12.6% plunge in new dwelling commencements in the March quarter.
The second theme of the June Board meeting was around taking some time to assess the impact of the earlier reductions, with the Minutes noting: “there had not been time to assess the effects of the earlier reductions in the cash rate”.
Since the last Board meeting there has been no extremely adverse global development. The Chinese data would be continuing to surprise the RBA on the downside while Europe continues to be a rolling crisis followed by a ‘band aid’ bail out. Over the last two weeks during my time in Europe I have been struck by the utter despair and uncertainty associated with European developments. The US, as we expected, remains caught in a secular phase of low growth as agents adjust to the overhang of excessive debt in the household and government sectors.
However, as indicated by global bond rates, there has been no further step down in global financial conditions which might prompt the Board to move in spite of its clear intentions as indicated in the Minutes.
There is also the historical tendency for the Board to eschew policy changes at meetings before the release of the CPI, which is due for release on July 25. Of the 35 decisions to move rates since 2001 only 7 have been in the month preceding a CPI release, while 16 have been in the month directly following the CPI release. That argument, however, is less relevant in an easing cycle with 5 moves directly before a CPI release, 5 moves straight after and 6 moves in the ‘middle’ month. In contrast the comparable pattern for a tightening cycle is overwhelmingly in favour of the meeting directly after the CPI release, with 11 moves directly after 2 moves before and 6 moves in the middle month.
Markets are still pricing in a reasonable chance of a move in July. They are also expecting 100bps by year end, which is more than our own expectation. However, markets should not be seen as being solely driven by expectations for monetary policy. They are a combination of monetary policy expectations, a ‘flight to quality’ that is dragging down global interest rates and the hedging positions of large global investors. In the extreme, the current 1.6% nominal rate on U.S. 10 year bonds is unlikely to be solely driven by the sum of policy expectations and risk/inflation premia. While the Federal Reserve has indicated that rates are on hold until late 2014, it also estimates that the long run overnight Federal funds rate is 4% – 4.5%, hardly pointing to a 1.5% 10 year bond rate.
Our argument that financial conditions are hardly stimulatory, interest rate sensitive parts of the economy are struggling, inflation is low and that global uncertainty will continue to undermine confidence still support our forecast of a further 75bps in RBA rate cuts.
We expect the confirmation of low inflation will prompt the Board to cut by 25bps following the meeting in August. A follow up move in September now seems probable with a further ‘post CPI’ adjustment in November still likely.