Below is Westpac’s chief economist, Bill Evans’ take on today’s Statement of Monetary Policy (SoMP) released by the RBA. In light of the SoMP, Evans argues that two further cuts to interest rates will be required to support growth as the mining boom fades.
Cuts growth forecast to well below trend; decidely downbeat on near term.
In its statement on monetary policy for August, the bank has made one significant change to its forecasts. That is a reduction in the growth forecast for 2013 from 2.5% to 2.25%. Surprisingly, it did not change its forecast for growth in 2014, choosing to retain the 2.5%–3.5% range. That is significant because 2014 is the period for which any interest rate changes should be expected to have an impact. It may be that without the August rate cut, it would have been necessary to lower that growth forecast; whereas having made the cut and being mindful of the 10% fall in the exchange rate that, was sufficient to justify maintaining the growth forecast.
The commentary in the statement reflecting the revised growth forecast for 2013 is downbeat for the near term outlook. The bank reports important results from its liaison with business which indicate a necessary downward revision in consumer spending growth and non-mining investment. There has also been a downward revision to the profile of mining investment, with the liaison indicating that “few new commitments to mining projects and a lack of current expenditure on the development and planning work”. Liaison has also indicated that firms remain cautious about hiring staff and that a key reason behind the downward revision to GDP growth in 2013 is a lower forecast for employment growth. The unemployment rate is expected to continue to rise, but then “stabilise and then start to decline toward the end of the forecast horizon”.
Given the slower momentum from 2013, it is reasonable to question why the forecast for 2014 was unchanged. In that regard, the bank points to the importance of the boost to economic activity from the depreciation in the currency which offsets the downward revision to the forecast path of mining investment. Whereas previous statements from the bank reflect uncertainty on the timing of the peak in the mining investment cycle, this statement indicates that the bank believes that the peak has already been reached, and it expects mining investment to decline over the next year before falling away more noticeably after that.
Further justification for revising down 2013 comes from the bank’s liaison which indicates that firms are planning only modest investment growth. Office vacancy rates have increased, although non-residential construction predominantly in the healthcare sector will be boosted. The more optimistic growth forecasts further out in the forecast period reflect the bank’s expectation that non-mining investment will “experience a stronger pick-up” due to low rates, currency depreciation and strong population growth.
Growth in government spending is expected to be low over the forecast period.
The inflation outlook is unchanged in these forecasts, despite the 10% fall in the currency. This is because the softer demand in the near-term which will also weaken employment growth is expected to constrain wages growth. Broadly speaking, the upward pressure from tradeable goods inflation will be offset by downward pressure in non-tradeable inflation due to weak nominal wages growth and productivity gains.
These forecasts have been formulated around some guidelines which the bank points out. These are that a 10% depreciation of the exchange rate stimulates GDP growth by 0.5ppts to 1ppt over two years, whilst also increasing inflation by 0.25ppts to 0.5ppts over each of the following two years. The downward revisions to mining investment and consumption in the near term preclude the bank from revising its growth forecasts until December 2015 where growth is forecast to reach 3.5%. The May statement did not include a December 2015 forecast, but 3.5% looks to be remarkably optimistic, particularly given that, by the bank’s own admission, mining investment will be falling away markedly in 2015.
The forecast for world growth has been revised down, reflecting the slowdown in China, although the bank seems satisfied that this slowdown will be orderly. In turn, the terms of trade have also been revised down for the forecast period.
While the bank’s forecasts assume a fixed exchange rate of USD0.90, there is an interesting discussion around the possibility of a further depreciation in the AUD, “it is also possible that just as the high terms of trade led to a high exchange rate over recent years, a lower terms of trade and lower investment could lead to a further depreciation of the exchange rate”.
Conclusion
This statement paints a very subdued picture of the Australian economy in the near term. Growth of 2.25% in 2013 is markedly below trend rather than the term that is often used of “a little” below trend. Near-term prospects for consumer spending, employment growth and investment (both mining and non-mining) have been revised down. The peak in the mining-investment cycle is now assumed to have passed. There is considerable confidence that wages growth will remain subdued due to weakness in the labour market. The bank correctly notes that a key risk is ongoing caution from households due to slow wages growth and resulting weak consumption growth, especially if the labour market weakens further. The upside risk is around house prices boosting wealth, confidence, consumption growth and household leverage. Our view is that those downside risks markedly outweigh the upside.
On the investment front, the slowdown in mining seems assured, whereas the offsetting upswing in non-mining investment faces challenges. Businesses confidence levels are weak; capacity utilisation is low; and their actions by constraining employment are feeding back onto them through soft demand from the household sector.
It appears from this statement that the bank is expecting ongoing weakness in domestic demand despite the 225bps in rate cuts. That weak domestic demand, by constraining wages growth, continues to contain inflation pressures and allows scope for further stimulus. The key penultimate paragraph in the overview section of this statement, whilst used to justify the August decision to cut, does point to a very confident bank around its inflation task, “the recent price and wage data do not suggest any lessening of that scope from an inflation point of view and the expectation is for inflation to be consistent with the target even with the effect of the depreciation”.
The emphasis on the depreciation in the statement coupled with the clear disappointment in the results of the bank’s liaison work and the strong confidence that inflation pressures will be contained point to the bank seeing the need for an even weaker currency to provide further stimulus. My reading of this statement indicates that without a further marked depreciation, the bank expects that the soft data prints over the course of the next few months will require further stimulus.
Our forecast is for a broadly stable AUD and two further interest rate cuts which will be required to further stimulate the economy as the mining boom fades, government spending slows, and consumer/business caution prevails.
