From Bill Evans at Westpac:
Growth to December 2015 is forecast at 2.5% compared to 2.75% in the February Statement and forecast growth to December 2016 has been lowered from 3.5% to 3.25%. These changes are in accordance with our expectations and of course provide convincing justification for the decision to cut rates by 0.25% at the May Board meeting.
However we were surprised that the Bank has also decided to lower its medium term inflation forecasts. It has retained its 2.5% forecast for underlying inflation in 2015 but lowered the 2016 forecast from 2.5% to 2.25% and has similarly adjusted the forecast to June 2017.
The expected dynamics around the growth outlook are summarised by: “growth below trend for longer”. The key change is a further downward revision to the outlook for non-mining investment. This is supported by the recent ABS Capex survey and the Bank’s own liaison which emphasises that “firms are reluctant to undertake significant investment until they see a durable pick up in the growth of demand”. That growth is not expected to lift above average until mid 2016 while stronger demand will also come from the benefits of the lower Australian dollar. The indirect effect of the fall in commodity prices is taking a further edge off mining investment as exploration and some Capex, particularly in oil and gas, are being deferred. In addition weaker export growth is also predicted as a result of reduced production particularly from uncompetitive local producers in the resources sector.
This weak demand and a more cautious business sector will weigh on the labour market with the recent soft wages growth expected to continue for some time and the unemployment rate predicted to rise further to peak at 6.5% in mid 2016.
Consistent with recent speeches the Bank emphasises that strong conditions in existing housing markets are limited to Sydney and, to a lesser extent, Melbourne. The assessment of the property market does not indicate excessive concern. It is even pointed out that while loan approvals to investors have continued to grow, “the pace of growth has slowed”.
The commentary around the global economy is also more downbeat: growth in China is observed to have “eased further”; Japanese activity somewhat mixed; the rest of east Asia “to have slowed a little”; and growth in the US having “moderated”.
Consistent, but somewhat surprisingly, with this weaker activity profile the Bank has also chosen to revise down the medium term inflation outlook. That revision is also supported by the expected lagged indirect effect of the recent fall in fuel prices.
Of course that downward revision takes the lower currency into account. The Bank estimates that the fall in the AUD has already added around 0.5 ppt’s to annual underlying inflation. While its forecasts are based on a USD 0.80 dollar the clear implication is that these low inflation forecasts can still be sustained even with a weaker AUD.
While all these changes appear sensible the risk around the outlook appears to be the expectation that growth in consumer spending will lift “above average from mid 2016”. That will have to be supported by a solid fall in the savings ratio although the Bank only expects it to decline “a little further”. The question remains as to whether the household sector will burst back into life in an environment where wages growth is weak; a rising unemployment rate undermines households’ expectations of job security; and , as a result households remain cautious.
The implications for policy are quite clear. The Bank is now expecting inflation to remain in the bottom half of the 2-3% target band in 2016. At present it is also expecting that growth will lift from a modest 2.5% in 2015 to an above trend 3.25% in 2016 with the catalyst being above trend growth in household expenditure. Prospects of that growth lift are likely to be sufficient to keep policy on hold despite the lower inflation performance. However, should developments with the household sector evolve through the second half of 2015 in a way to suggest that this above trend growth will not be achieved there is now clear policy flexibility to further reduce rates.
It has been our view that the Bank will hold rates steady for at least the next six months until it can test its optimistic outlook for the household sector. If it appears that the timing of above trend growth in consumption has to be pushed back even further to, say, 2017 then the clear policy option will be to crank up another easing cycle. The market is currently giving the probability of another cut of about 50%. The risks around the Reserve Bank’s story are to the downside but if it becomes clear that 2016 will be another below trend growth year it has the flexibility to cut by cumulatively more than just 25 bp’s out to mid -2016.
There has also been a much more sensible approach to policy guidance. We were surprised to see that the Governor gave no guidance following the May rate cut preferring to emphasise “recent encouraging trends”. In this Statement a more balanced signal is used: “The Board will continue to assess the outlook and adjust policy as needed to foster sustainable growth in demand and inflation outcomes consistent with the inflation target over time”. This statement, whilst not as strong as we would have preferred, at least emphasises the possibility of action. It clearly addresses any concerns in the market that the Bank sees 2% as the low point in the cycle.
Outlook
Most of the sentiment expressed in today’s Statement comes as no surprise. In fact our support for a likely rate cut in May was predicated on the Bank’s downward revision to growth specifically because of a weaker outlook for business investment and exports. However, we are surprised that the inflation outlook has been revised down specifically to expect underlying inflation to hold in the bottom half of the target band in the medium term. That outlook affords clear flexibility to ease rates further should the current above trend forecast for growth in 2016 have to be revised back to another sub-trend year. Combined with guidance indicating that the Bank stands prepared to act we have to conclude that this Statement is signalling an appropriate soft easing bias.
However, we do not think that the Bank will be quick to act on that bias, notwithstanding the elevated level of the AUD. For now we are comfortable with our call that rates will remain on hold through 2016.There is time to assess the progress of the household sector and continually test whether above average growth in 2016 is a likely prospect.
Sadly, it’s too late to influence the currency.
