From Bill Evans at Westpac:
The most important result from the minutes of the monetary policy meeting of the RBA Board was to finally nominate the Bank’s estimate of the “new neutral real interest rate for Australia”. In other countries it has been recognised for some time that the neutral rate has fallen particularly since the global financial crisis in 2007. Prior to that, it had generally been accepted that the neutral nominal cash rate was around 5%. The minutes highlight that the Bank now believes that the neutral nominal cash rate is around 3.5% indicating a neutral real rate of 1% on the basis that medium term inflation expectations are around 2.5%.Consequently any move back to neutral would involve around 200 basis points in tightening.
Note that the analysis refers to the “neutral nominal cash rate”. So, for instance, the increases in mortgage rates that we have recently seen (average of 0.28% across the whole book including 0.76% for interest-only investors) would not be taken into account as part of the 200 basis points in tightening. If the mortgage rate increased by a further 200bps, the evidence of 2011 suggests that house prices would likely fall – hardly what one might assess as a neutral policy stance. Overall, in the current circumstances, this neutral rate, looks too high.
Arguably, the discussion around the neutral rate can be interpreted as laying the foundation for a tightening cycle. However with uncertainty around wages and inflation; the consumer; and, of course, the labour market and housing it would be inappropriate to over interpret this signal.
Our specific interest in the minutes is around the revised assessment of the housing market; the labour market and possibly the exchange rate. Certainly the final paragraph in the “Considerations for Monetary Policy” section notes that “nevertheless they assess that current economic conditions in Australia and the outlook for growth and inflation meant that developments in the labour and housing markets continued to warrant careful monitoring”.
The commentary around the labour market is definitely more confident. Not only do the minutes refer to “employment growth had been strong in May for the third consecutive month” but it is also noted that “forward looking indicators of labour demand … had remained positive and generally consistent with the patterns of employment across states and industries”. This commentary suggests that the Board is reasonably comfortable that the recent upswing in employment can be sustained. The only note of caution around the recent developments is that “the underemployment rate … had remained elevated”.
We are aware that subdued wages growth is a significant concern for the Bank. That remains a consideration. However, the minutes did point out that the recent Fair Work Commission decision to increase award wages and the national minimum wage by 3.3% (affecting around 40% of workers) was markedly higher than the 2.4% awarded in 2016.
Commentary around the housing market continued to note that conditions vary across the country, although the “auction clearance rates in Sydney and Melbourne had softened recently suggesting that conditions in these markets had eased somewhat”. It was also noted that the impact of the prudential supervision measures were yet to have their full effect.
At the time of the board meeting, the Australian Dollar was trading at around USD 0.76. Not surprisingly, the minutes therefore retain the standard terminology “an appreciating exchange rate would complicate this adjustment”. With the currency now at USD 0.78, the Board is likely to be more concerned about its impact on the rebalancing process.
Conclusion
As the minutes point out, financial market pricing for RBA policy has “shifted to indicate some probability of an increase in the cash rate by mid-2018”. The most important development behind this outlook is the improved conditions in the labour market. As noted, the Bank is encouraged that lead indicators continue to point to further improvements in conditions. The unemployment rate is now only 0.5% above the generally accepted full employment rate for Australia. A sustained move towards 5% would certainly encourage the Bank to consider higher rates. However, there would need to be some evidence that wage pressures were also responding since underlying inflation remains anchored below 2%.
The implications for policy from the housing market are less clear. The macroprudential policies have already resulted in higher mortgage rates, and as noted in the minutes, pressures in the housing market appear to be easing. However, until the full impact of the macroprudential policies can be assessed, raising interest rates might prove to be premature.
Recall that the Bank’s current forecasts for GDP growth in 2018 are an above trend 3.25%. That contrasts with our own forecast of only 2.5%. Our forecasts envisage ongoing caution from the consumer; no significant recovery in non-mining investment and detraction in growth from housing construction. Today’s minutes do not really indicate that the Bank is sufficiently confident that this profile will be averted .It will need a lot more time to confidently make that assessment.
Furthermore, the growth profile which we described is unlikely to be consistent with sustained improvement in the labour market. While the short-term outlook may be positive, we expect that the unemployment rate will edge back towards 6% over the course of 2018. The Bank will be cautious to confirm its positive outlook before the need to raise rates.
Despite a more confident Bank and its decision to set out its new so-called “neutral target”, our forecasts remain consistent with the cash rate staying on hold throughout 2017 and 2018.
Quite right.
