Another economist abandons rate cuts

Woho! There’s only MB and Tim Toohey at Goldman Sachs left in the rate cut camp:

In a change of forecast, we no longer expect the RBA to trim the cash rate in August. Indeed, the “period of stability” RBA officials expect now looks likely to last well into 2015. We have changed the rate call, but have not made material changes to our macro forecasts, which continue to foresee below-potential output growth, rising unemployment, and benign inflation. In fact, domestic demand weakness is likely to persist into the second half of this year, so the risk of a rate cut this year remains higher than the chance of a hike. Recent developments, however, outlined below, mean the new base case is that the RBA will be on hold for some time from here.

We do not forecast the first rate hike until the second half of 2015, by which time the base of growth in the economy should have broadened away from resource exports, household spending and home-building ought to have firmed, and AUD likely will be lower. Our policy forecasting tool has been signaling the end of the easing cycle, but we have been fading this message. The tool can underestimate the impact of structural drags, like the strong AUD, which will help keep domestic growth below trend for some time yet.

Lower peak in jobless rate at 6.25%

We had forecast a final cut in this cycle for three main reasons: 1) the stop-start transition away from mining investment as the main driver of activity, which is delivering below-potential GDP growth and a rising jobless rate; 2) the stubbornly high AUD, which continues to hobble much of the traded goods sector and is helping to suppress inflation; and 3) growing fiscal drag, which left monetary policy as the sole free policy instrument. These factors remain important influences on policy, but no longer seem sufficiently troublesome to trigger a final rate cut in this cycle. Instead, they now argue for the maintenance of the current level of policy support.

Indeed, there have been positive developments of late in each of these main policy influences. First, last week’s business investment report provided long-awaited signs that investment intentions outside mining are starting to pick up. Ex-mining capex had been a prominent missing piece of the growth rotation jigsaw RBA officials have been assembling. The broadening of the investment base will help offset the drag as miners slide down the steep face of their “capex cliff.” A slightly more optimistic corporate sector is consistent with our decision to nudge down our forecast for the peak in the jobless rate later this year from 6.5% to 6.25%. This change also was prompted by decent monthly outcomes of late, which have conspired to keep the jobless rate below 6%.

Second, the elevated AUD remains a stiff headwind for the economy, but J.P. Morgan’s FX Strategy team anticipates a weaker currency by year-end, which will help ease monetary conditions. And, the recent slump in bulk commodity prices means the risk of a steeper drop in AUD has increased. RBA officials sidestepped recent opportunities to verbally muscle down AUD, despite the unit remaining “uncomfortably high,” but the widening gap between falling commodity prices and stubbornly high AUD increases the chances the central bank will resume more assertive verbal intervention , which would weaken the case for further policy support.

Third, the additional fiscal drag we anticipated from the budget looks increasingly likely to be whittled away by senators in the Parliament who have promised to block many of the government’s key measures. We still anticipate a cumulative drag of nearly 2%-pts over the next four years, but this stems largely from policy decisions made before last month’s budget. Unexpected voting outcomes in the senate could change this, but, for now, the additional drag is small. Meanwhile, state-level governments have announced material increases in infrastructure investment, which will mitigate the fiscal drag from the federal level.

RBA’s reaction function has evolved

Moreover, there has been a change of tone from Bank officials of late, particularly around the outlook for employment and investment, implying they believe the economy has enough policy support. The hurdle for them to provide further accommodation, then, is higher; it would take a lot to change their minds and there are no calamities embedded in our forecasts. Officials dropped the implied easing bias back in February, the first sign the RBA’s reaction function was evolving. More recently, Bank officials seem content that the “substantial” policy easing delivered since late 2011 is working to ensure output growth returns to trend over time and that inflation is consistent with target.

Evidence of policy traction in house prices and consumer-related indicators had become clear earlier this year, even though consumer confidence fell in the wake of the budget austerity. We expect the negative reaction to the budget to weigh on retail spending in coming months, which is another reason the RBA will be in no rush to start unwinding current policy accommodation.

We do not see recent healthy house price gains and evidence of speculative investment in housing as reasons for the RBA to embark on an early hiking cycle. House price gains thus far have not been accompanied by a marked acceleration in credit growth, partly because many investors are sourcing capital from outside the domestic banks. This fact, and the near-absence of first home buyers in new lending, explains why growth in credit to housing, despite a modest improvement, remains close to 35-year lows. That the RBA would raise the price of capital without evidence of excess demand for credit does not make much sense to us. Moreover, there are signs that some of the enthusiasm in housing is cooling, with prices falling recently, even though auction clearance rates and sales volumes remain high.

A languid start to the tightening cycle

On the new forecast profile, then, after the first hike, we expect only 25bp of additional tightening over the remainder of calendar 2015 (CY2015). This will be a languid start to the tightening cycle, much like the cycle that started in 2002, which ultimately stretched over six years. Officials’ likely tolerance of a return to trend-like growth in 2015 will be conditioned by well-behaved inflation (due largely to the still-elevated AUD and benign wage growth) and the economy’s ongoing headwinds, including a dwindling industrial sector, which already has halved as a share of GDP over the past two decades. The cash rate is likely to keep rising in CY2016 as the base of growth in the economy broadens, but by only another 50bp. At 3.5% by end-2016, the policy stance would be broadly neutral.