Via Bill Evans:
Westpac has extended its financial forecasts to end 2020. We expect the RBA cash rate to remain on hold through 2020 . The tightening of financial conditions which is normally associated with increases in the RBA cash rate has been replaced, in this cycle, with macro prudential policies and rising wholesale interest rates. Accordingly Australia’s participation in the global tightening cycle has taken a different form.
To date Westpac has issued public forecasts for the outlook for growth and financial markets to March 2020.
These forecasts are incorporated in the August Market Outlook publication.
We are now extending those forecasts to end 2020.
Last year around this time we surprised markets by forecasting no change in the RBA cash rate out to end 2019. At the time markets were priced for at least three rate hikes (25 basis points per move) and the overwhelming majority of forecasters were anticipating the rate hike cycle to begin in 2018.
Markets have now partly moved into line with our view with only around a 50% probability of one rate hike by the end of 2019. Furthermore, 65% of forecasters in the Bloomberg survey are still expecting the cycle to begin by the third quarter of 2019.
Our view is that the cash rate is likely to remain on hold not only through 2018 and 2019 but also 2020.
Some may argue that we are unrealistically forecasting that Australia will completely miss the global rate hike cycle if rates remain on hold for such an extended period.
We differ from that view arguing that financial conditions are affected by more forces than just the RBA cash rate.
Through 2017 and 2018 we are already observing tightening conditions in the absence of RBA rate hikes.
This tightening is emanating from heightened macroprudential policies from the banking regulator APRA and the rise in wholesale funding costs for banks and corporates.
New lending to housing investors has fallen by 25% over the last year; housing credit growth is likely to slow from 6.5% in the year to September 2017 to 4% in 2018/19 and 2019/20. The bank bill rate has “settled” at around 25 basis points above those levels, which prevailed in previous years and is priced in markets to remain there for at least the next year or so.
As a direct reflection of that tightening in financial conditions we are now seeing housing markets weakening with outright price falls in both Sydney and Melbourne.
These price corrections look set to be sustained for at least the remainder of 2018 and 2019 with soggy markets likely prevailing through 2020.Housing markets typically recover when there is an increase in new buyers in the market. That increase can be attributed to a boost in affordability or a rise in confidence.
In previous cycles affordability has been boosted by multiple rate cuts from the Reserve Bank; lower prices; and rising incomes.In this cycle the Reserve Bank has made it clear that short of a major global financial shock (most likely emanating from China) or a major collapse in the local housing market, it will resist cutting the cash rate.
Neither of those scenarios figure in our central case.
Furthermore, we do not envisage a marked lift in income growth over the forecast period. Accordingly the “responsibility” for the restoration of affordability in the two major housing markets will accrue to prices. So an extended period of price weakness is required before we return to levels of affordability that will attract new buyers and stabilise the markets.
Confidence will also be a factor that will discourage new entrants over the 2019 period as the economy deals with uncertainty around the electoral process. In that regard the parties have significant differences regarding tax policies for property investors.
The global environment through 2019 and 2020 will not signal any need to further tighten financial conditions. We expect that the US economy will be slowing through the second half of 2019 and through 2020. We currently anticipate that the Federal Reserve will go on hold in the second half of 2019.
The risk to this scenario is a sharper increase in inflation in 2018 and 2019 as the US economy deals with the “cocktail” of an unemployment rate well below full employment and a strong fiscal stimulus. This would result in a larger and longer tightening cycle through 2019 to be followed by an even sharper slowdown in 2020.
China has signalled its commitment to reduce leverage. This is likely to be a sustained commitment through 2018; 2019; and 2020 as the authorities grapple with the need to diffuse the distortionary impact of the largely unregulated shadow banking system.
As we have seen in recent weeks the authorities will have no patience for a sudden slowdown in growth (likely precipitated by the reduced leverage and the concerns around trade wars). However the authorities are still expected to accept a gradual slowing to a growth pace somewhat below current market expectations, (Westpac expects China’s growth rate in 2019 and 2020 to slow to 6.0%).
With the US and China in a slowdown phase it is unlikely that Europe or the emerging markets will be in a position to fill the “growth hole” that would develop in 2019 and 2020.
For Australia, we continue to expect that inflation will struggle to sustain the bottom of the Bank’s 2–3% target zone. Low inflationary expectations; ongoing slack in the labour market; very limited upward pressure on wages; and falling energy prices will all keep the inflation rate anchored around 2%. (Recall that headline inflation has consistently undershot 2% for virtually all of the period since September 2014 and the Bank is predicting 1.75% for 2018).
In fact the Bank’s own forecasts are not consistent with the pre conditions for a tightening until well into 2020. “It is likely to be some time before we are at full employment and the inflation rate is comfortably within the target range on a sustained basis”. (Governor Lowe, Opening Statement to the House of Representatives Standing Committee on Economics, August 17).
Full employment is defined at 5% and the Bank does not expect to be there until the second half of 2020 while inflation is not forecast to be above 2% until 2020. As has been noted by Bank officials it is uncertain whether 5% is, indeed, Australia’s full employment rate. Evidence from the US and some other countries points to the full employment rate being lower than in previous cycles largely due to structural change around technology and globalisation.
We are also sceptical about Australia’s growth outlook.
The Reserve Bank is forecasting GDP growth of 3.25% (2018); 3.25% (2019) and 3% (2020). That compares with our forecasts of 2.7%; 2.5%; and 2.8%.
The key dynamic here is an expectation that the household can continue growing its consumption spending at around a 3% pace (note that the Bank consistently refers to the outlook for consumption being a source of uncertainty).
That will require a solid lift in wages growth (Government Budget forecasts of 3.25% in 2019/20 and 3.5% in 2020/2021) to support incomes; a negligible negative wealth effect from the falls in house prices and a sustained growth in employment averaging above 1.8% over the next few years.
We are more cautious about the outlook for wages growth expecting low inflationary expectations and considerable ongoing slack in the labour market to contain wage pressures. We also expect the current slowdown in employment growth to be sustained through 2019 particularly as the uncertainty around political developments weigh on business confidence, spending and employment plans.
In turn a cautious consumer is also likely to temper investment plans in plant and equipment.
While government spending will remain robust its contribution to growth will ease. Exports are also likely to support growth although the height of the boost from the LNG will be 2019 as production levels are expected to peak in that year. To an extent the slowdown in resource export growth will be compensated by the boost to services exports from the lower Australian dollar.
Conclusion
The Australian economy is currently being subject to tightening financial conditions despite the RBA cash rate remaining on hold. The impact of these tightening conditions is likely to last through 2018; 2019; and 2020. The Reserve Bank is unlikely to ease rates to offset these forces given the “high bar” it has set for cutting rates.
APRA and the Reserve Bank have used other policies to address Australia’s household debt burden. These policies seem likely to be sustained for a number of years. No further conventional tightening of policy through a rate hike from the Reserve Bank seems likely – even as far out as 2020.
The Bank sets the unemployment rate and inflation as the keys to triggering higher rates. Our unemployment and inflation forecasts are consistent with steady rates in 2020.
Other issues supporting our view that rates will remain on hold through 2020 are a slowing in the global economy, particularly from the second half of 2019; a long adjustment process for house prices; low inflationary expectations; weak wages growth and a negative wealth effect.
We confirm our expectation that the Australian dollar will reach USD 0.70 in 2019 but, in response to a slowing US economy; the Federal Reserve going on hold and Australia’s growth rate bottoming out in 2019 we expect that the AUD can recover slowly to around USD 0.75 through 2020 partly reflecting that weaker US dollar.
Next RBA move is down.
