Sack Phil Lowe and install Bill Evans

Because he makes so much more sense than the RBA governor that it is embarrassing:

This GDP print for the December quarter of 2018 shows the Australian economy having slowed in the second half of 2018 from a 4% annualised pace in the first half to a 1% annualised pace in the second half.

The challenge for the Reserve Bank will be to credibly maintain its GDP growth forecasts at 3% in 2019 and 2.75% in 2020. Expecting a lift in the growth momentum from 1% to 3% could only really be justified if the economy was expecting to benefit from a significant stimulus. But global growth is slowing; the residential construction cycle has clearly turned; the AUD remains in a stable range; monetary policy is on hold and fiscal policy will continue to be constrained by the perceived need of both political parties to predict a surplus in 2019/2020.

Consequently the Reserve Bank is likely to see the need to further revise down its growth forecasts when it announces its revised forecasts in the May Statement on Monetary Policy.

Those are likely to have an upper bound of 2.75% in 2019 and 2.5% in 2020. That is a “trend” forecast for 2019 and slightly below trend in 2020. Such forecasts are likely to still be assessed as consistent with steady policy with a clear “easing” bias.

With the residential construction cycle now turning down; business investment mixed; the savings rate now edging up; and house prices and new lending contracting, prospects for being able to maintain those forecasts in August look bleak. We expect by the August Statement on Monetary Policy, the growth forecasts for both 2019 and 2020 will have both fallen below potential (2.75%), probably not to Westpac’s current forecasts of 2.2% in both years but sufficiently below trend to invalidate any forecast of a falling unemployment rate and solid wages growth.

In such circumstances, with 150 basis points of “flexibility”, the RBA is expected to cut the cash rate by 25 basis points to 1.25% and follow that up with a second cut of 25 basis points in November recognising confirmation of persistent below trend growth. Under such a benign growth outlook it will also be necessary to further push back on the expected timing of the return of underlying inflation into the 2–3% target band. This expected scenario is consistent with Westpac’s forecast for two rate cuts in August and November.

There were a number of significant developments in the GDP report. Firstly we saw an extension of the contraction in new dwelling construction from the September quarter following a particularly strong first half. Westpac expects this is the start of a long run of falls in residential construction reflecting the downturn in dwelling approvals and an expected further contraction as tight funding conditions and falling house price expectations deter both demand and supply of new construction.
Secondly, we saw a second particularly weak print on consumer spending (0.4% following 0.3%) reflecting weak income growth and some early signs of a negative wealth effect as the savings rate lifted from 2.3% to 2.5%. Wages growth is lifting only very slowly while employment growth is expected to slow in 2019 as political uncertainty, global tensions around trade and softening demand weigh on business employment and investment intentions. There are lags but the tepid growth in the second half of 2018 is likely to weigh on employment growth in 2019.

There is also likely to be a further wealth effect on consumption as the impact of falling house prices on household balance sheets plays out. Evidence of a wealth effect during the boom period for house prices is apparent in the 1.7–1.9 ppt fall in the savings rate in NSW and Victoria. We expect this to gradually unwind over 2019 and 2020 restraining annual consumption growth to around 2.0% in both 2019 and 2020 with an expected lift in the savings rate from 2.5% to near 5% by end 2020. That rise in the savings rate and associated low consumption growth is the main factor behind the expected soft GDP growth outlook.

House prices will be important in 2019. Even though prices have fallen by 13% from their peak in Sydney and 10% in Melbourne, these adjustments follow cumulative increases of 60% and 44% respectively over the previous four years. Affordability is still stretched in both cities. Unlike previous cycles where affordability was improved through sharp reductions in interest rates and relatively firm income growth, the necessary restoration of affordability in this cycle will need to come from prices. We estimate that further falls of 10% or more in these cities (over 2019 and 2020) will be required to restore affordability given limited interest rate flexibility and a restrictive credit environment. In previous housing downturns interest rates played a critical role in restoring affordability. With the RBA cash rate already down at 1.5%, there is very limited scope for interest rate cuts to perform that traditional role.

As we have recently seen in Perth, affordability can be restored but prices can still fall further if credit is tightened. While there is some unease in official circles around a possible credit squeeze we expect that the regulators will be comfortable to maintain greater scrutiny on lending practices. This is despite decisions by the regulator to release previous policies to limit investor and interest only loans.

There are also challenges with an entrenched low inflationary environment. On a calendar year basis headline inflation has been below the RBA’s 2–3% target range since 2013. The concern is that such a protracted period of low inflation is impacting expectations. Our forecasts indicate that headline and core inflation will not reach 2% until June 2021. The RBA recently pushed back its forecast for underlying inflation to reach 2.25% from 2019 to 2020.

On the positive side, government infrastructure spending, continues to lift with overall government spending up 6% in 2018. The mining investment contraction has bottomed out and there is some evidence of a likely modest lift in new mining investment largely focussed on iron ore and lithium.

Services exports are booming. Education spending rose 15% in 2018 while total services exports lifted 9.7%. Overall net services exports contributed nearly 0.5 percentage points to GDP growth. Importantly, this is not specifically a China story, with China explaining around 20% of total services exports, including 33% of education exports. The China story remains vulnerable to any policies aimed at boosting China’s shrinking trade surplus.

Household income growth is expected to slow. We expect employment growth to slow to 0.6% in 2019 down from 2.2% in 2018. pushing the unemployment rate up to 5.5% by yesars end. Wages growth is also lacklustre, partly because considerable slack remains in the labour market. The underemployment rate is forecast at 8.5% by end 2019, largely unchanged since December 2014 despite a drop in the unemployment rate from 6.1% to 5.0%. Accordingly wages growth is expected to remain sluggish – this has been the case even in NSW where the unemployment rate has fallen just below 4.0%.

The markets’ caution on the federal funds rate seems well placed

On February 18 I returned from a two week marketing trip in the US where I met with a number of Fed officials; real money managers; hedge funds; and corporates. One consequence of this visit has been the decision to revise our forecast for the federal funds rate in 2019 from hikes in June and September to one hike which will be delayed until December.

While it is accepted that the consumer will continue to support growth, other, more cyclical parts of the economy, are seen to be slowing. These include business investment; housing and exports. Even the economists who confidently expected multiple rate hikes from the Federal Reserve as recently as early December have now retreated to expecting “maybe” one more hike near the end of the year. It is accepted that it will take considerable time for the Federal Reserve to make a case for higher rates. The earliest likely opportunity would be around the Jackson Hole Conference in August. The Chairman is also likely to need to link any further hikes to a clear rhetoric around the economy – the Fed did not raise rates, it was the US economy.

Proponents of the “neutral” setting approach accept that the measure of neutral is too imprecise to be able to assess that rates are at or above neutral. It was much easier in 2018 when rates were clearly below neutral and the economy had tailwinds – fiscal policy; global growth and easy financial conditions. in 2019, rates are 100 basis points higher; the stimulatory effect of fiscal policy is easing and should a range of spending programs expire by 2019 H2 (as currently legislated) fiscal policy will become a headwind. In addition, global growth is slowing and financial conditions are tightening.

While equities usually have a relatively low weight in FCI’s (around 5–10%) they are given more significance in assessing the outlook for the economy – as a proxy for risk and for businesses’ outlook for growth. While the share market has regained much of the losses of early December, persistent volatility warrants caution. “Neutral” or R* is broadly defined as that interest rate setting that is consistent with 2% inflation (as measured by core PCE) and potential growth. Although, in 2018, inflation had hovered below the 2% target, growth near 3% was substantially above the measure of potential, 1.75%–2.00%.

For 2019, growth is expected to slow to 2–2.5%, slightly above potential, but inflation is expected to remain “sticky” around 2%, indicating that policy is very close to “neutral”. We must also respect the argument that inflationary expectations need to be anchored around 2%. Allowing inflation to lift above 2% to emphasise symmetrical policy is generally supported. There is universal confidence, almost complacency, that prospects for a “blow out” in inflation are limited, and risks on inflation continue to be pitched to the downside.

From my perspective the risk with this benign outlook for policy is around the labour market and wages. Responding to the tightening of conditions in the labour market (although overstated by the headline unemployment rate due to ongoing slack associated with the low participation rate) we have seen upward pressure build for wages growth. In 2016 and 2017 average weekly earnings grew around an annual pace of 2.5–3.0% – that has now lifted to around 3.5% (six month annualised). Momentum in the jobs market does not seem to be easing and a reasonable view is that wages growth will continue to climb. The outlook for wages growth is mixed but generally relaxed – labour’s bargaining power has diminished sharply; businesses have limited pricing power to pass on wage increases; business is committed to labour saving investments; and wage and price expectations are low.

Discussions highlight the lack of a relationship between wages growth and core PCE (one economist told me he worked in the wages and prices section of the Federal Reserve Board’s research department for five years and was unable to prove a significant causal relationship). There is also limited “cyclicality” in core PCE given “administered” prices and “shelter’s” prominence.

Theory, of course, dictates that wage growth is determined by inflation (or inflationary expectations) and productivity growth. The productivity outlook for the US is not encouraging so theory would dictate that a lift in wages should be associated with rising inflation. No response from inflation can only mean that inflation is being incorrectly measured or there is some other explanatory variable like “labour slack” that fills in the gap. Certainly there is a legitimate concern that wages might experience some non–linear surge as a “catch up” to the slow adjustment in the early stages of the recovery as wages did not fall despite the collapse in demand. For now, I am comfortable with the benign Consensus but am still troubled by a rising wages/sticky inflation scenario.

We doubt the recession thesis for the US. Recessions in the US are typically caused by a large financial shock (dot com bubble; GFC) or the FOMC losing control of inflation and over tightening. To date, there is limited evidence of extreme financial excess; while the “stable” core PCE represents no marked threat of overshooting. With only one more hike pencilled in for 2019 and no recession on the horizon, we expect the federal funds rate to be steady through 2020.

 

Comments

  1. I wonder if the RBA does performance reviews. So Phil in the last 12 months what projects and impact have you had.

    Well I’ve left the rates on HODL.

    Impact = gently falling dwelling prices.

  2. Yes lets go all the way and install a real bankster as head of the RBA.

    “fiscal policy will continue to be constrained by the ***perceived*** need of both political parties to predict a surplus in 2019/2020”

    How about instead of demanding rate cuts, why don’t we help shape public perceptions on what politicians should be doing?

      • Yes he and all the other bank economists, AMP, Macquarie etc are all singing in one voice – cut teh rates, cut teh rates. Sure they are all totally independent and credible until bank profits are threatened.

        So why doesn’t he suggest Westpac cut its own rates that it hiked under pretexts of having to comply with APRA, that no longer exist?

      • MichaelMEMBER

        I’ve had many meetings with Bill over the years.
        I think he is good, but sometimes a bit slow to react on the bigger issues.

    • BrentonMEMBER

      We can’t even get a consensus that there is a property bubble in this country, nevermind that it has been deliberately inflated by monetary policy working in tandem with rampant control fraud.

      The reality is that we’re a decade behind the rest of the Western world in suffering the necessary hardship to stoke the flames of populism (change).

      They’ll lower the rates into the crash. They’ll bail the banks and creditors out, with no criminal repercussions for persons responsible. They’ll initiate QE directed at financial assets (elites). Hopefully, sometime long after all this has played out, the average Australian will finally snap out of their apathy and challenge the crony capitalists.

      • I think in a quiet and unassuming way Phil Lowe is doing that.

        Not sure he will be successful with all the pressure being applied by the banks and mainstream commentariat, but for now he is offering some resistance.

      • BrentonMEMBER

        I agree, have said similar in the past.

        He has written about this exact situation earlier in his career:

        First, posing the question in terms of the desirability of a monetary response to “bubbles” per se is not the most helpful approach. Widespread financial distress typically arises from the unwinding of financial imbalances that build up disguised by benign economic conditions. Booms and busts in asset prices, whether characterised as “bubbles” or not, are just one of a richer set of symptoms. It is the combination of these symptoms that matters. Other common signs include rapid credit expansion and, often, above-average capital accumulation. These developments can, jointly, sow the seeds of future instability. As a result the financial cycle can amplify, and be amplified by, the business cycle.

        Second, while not disputing the fact that low and stable inflation promotes financial stability, we stress that financial imbalances can and do build up in periods of disinflation or in a low inflation environment. One reason is the common positive association between favourable supply-side developments, which put downward pressure on prices, on the one hand, and asset prices booms, easier access to external finance and optimistic assessments of risk, on the other. A second is that the credibility of the policymakers’ commitment to price stability, by anchoring expectations and hence inducing greater stickiness in price and wages, can alleviate, at least for a time, the inflationary pressures normally associated with the unsustainable expansion of aggregate demand. A third is that by obviating the need to tighten monetary policy, such conditions can allow the build up of imbalances to proceed further.

        Third, achieving monetary and financial stability requires that appropriate anchors be put in place in both spheres. In a fiat standard, the only constraint in the monetary sphere on the expansion of credit and external finance is the policy rule of the monetary authorities. The process cannot be anchored unless the rule responds, directly or indirectly, to the build up of financial imbalances. In principle, safeguards in the financial sphere, in the form of prudential regulation and supervision, might be sufficient to prevent financial distress. In practice, however, they may be less than fully satisfactory. If the imbalances are large enough, the end-result could be a severe recession coupled with price deflation. While such imbalances can be difficult to identify ex ante, the results presented in this paper provide some evidence that useful measures can be developed. This suggests that, despite the difficulties involved, a monetary policy response to imbalances as they build up may be both possible and appropriate in some circumstances. More generally, co-operation between monetary and prudential authorities is essential.

        https://www.bis.org/publ/work114.pdf

        He has essentially described the exact scenario that we find ourselves in and the subsequent monetary response that should be enacted. Obviously, he has inherited the bubble at it’s worst time, with next to no monetary room with which to move.

        …but when you look at the above, simplistic though it be, and apply it to his actions to date…. I agree, I think he is trying to manage the bubble deflation as best he can.

  3. BrentonMEMBER

    …with an expected lift in the savings rate from 2.5% to near 5% by end 2020. That rise in the savings rate and associated low consumption growth is the main factor behind the expected soft GDP growth outlook.

    House prices will be important in 2019. Even though prices have fallen by 13% from their peak in Sydney and 10% in Melbourne, these adjustments follow cumulative increases of 60% and 44% respectively over the previous four years. Affordability is still stretched in both cities. Unlike previous cycles where affordability was improved through sharp reductions in interest rates and relatively firm income growth, the necessary restoration of affordability in this cycle will need to come from prices. We estimate that further falls of 10% or more in these cities (over 2019 and 2020) will be required to restore affordability given limited interest rate flexibility and a restrictive credit environment. In previous housing downturns interest rates played a critical role in restoring affordability. With the RBA cash rate already down at 1.5%, there is very limited scope for interest rate cuts to perform that traditional role.

    Skewers the Australian economy (specifically the East Coast) in 2 paragraphs. It is another way of saying Australian households will knuckle down and attempt to restore their balance sheets (de-levering). Prices won’t stop at 20%, I think he knows this.

    Either way, what a cracker breakdown of the Aussie economy. Well worth the read.

  4. DominicMEMBER

    Which sensible person would want the job at this stage?

    The next crisis is dead ahead and the incumbent is going to endure an awful lot of heat when it arrives

  5. Yep!!! We need a Governor that will follow the singularly followed tradition of ‘Lower the rates!” Why change now??? Zero and Negative RAT rates have proven so successful so far. We need more consumption!

  6. Oh! This is the same bloke who, a month before the GFC hit, held out both arms, Keatingesque, and stated to the audience ‘It (the future) is all good as far out as we can see” As far out as they could see was confirmed s five years.
    Yep! That’s the sort of bloke we need. Real visionary.

    • MediocritasMEMBER

      Haha, I thought the same. Credit where it’s due though, he’s really good at arranging the deck chairs on the Titanic. Far better than most other professional deck chair arrangers, especially the clowns at the RBA.

      He just has a little blind spot for icebergs. Minor matter. Nothing to see here.

  7. Of course you agree with Bill Evans, he sings for your hymn book, and you from his. You are both commentators who have never had to make decisions of the magnitude of Phil Lowe.

    Love him or hate him, I think Phil Lowe is doing a great job under the circumstances. The speech he gave on Tuesday shows he has a sober and firm grasp of the facts and his decisions are well considered. It is easy to critic and poke holes as you constantly do, but you have to agree that based on the circumstances, Phil is doing a stellar job.

    • I agree he is on to it and I have heard him call a spade a spade in speeches. He has been given a s.. sandwich and will be crucified no matter which way he moves. All this positive outlook stuff is just RBA business as usual fluff to make the boss happy I think.

      • Yes – he does not want to cut and so he is applying the jawbone like mad and will use the slowdown in global growth as cover to cut rates once he has no choice.

  8. being optimistic on economic forecasts is part of job description in RBA – reason is simple the only tool they are left with is “boosting consumer confidence”

  9. I disagree with MB on this every time. First it won’t stimulate the economy at all as the rate will barely be passed on. Second it will likely crash our dollar and draw unwanted attention. Third we import everything these days so ++inflation. Fourth what will Phil do when a real crisis hits with no ammunition at all. Fifth he will screw savers even harder so they will spend less still. This whole situation is lose lose, he is boxed in.

Leave a reply

You must be logged in to post a comment. Log in now