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.