Bill Evans: SoMP brings rate cut risk forward

Via Bill Evans at Westpac:

The Reserve Bank’s May Statement on Monetary Policy (SMP) shows substantial reductions in the growth and inflation forecasts. GDP growth (to one decimal point) is now forecast at 2.6% for 2019 and 2.7% for 2020. That compares with 3.0% and 2.7% in the February Statement on Monetary Policy. The main explanations for the growth reductions for 2019 are consumption (2% down from 2.5%) and dwelling investment (–6.7% down from –4.5%).

As revealed in the Governor’s decision statement following the May Board meeting, the underlying inflation forecasts (trimmed mean) have been reduced from 2.0% for 2019 in the February SMP to 1.75% in May and the 2020 forecast reduced from 2.25% to 2.0%.

The forecast for the unemployment rate has been slightly increased, with the 5% unemployment rate still expected to hold through 2019 but the fall to 4.75% pushed back from December 2020 to June 2021.

It is very important to note that these forecasts are based on market pricing for the profile for the RBA cash rate and the current spot AUD. In February, markets had one cut priced-in for February 2020, whereas in May, one full cut is priced-in for August 2019 and a second priced-in for May 2020. The AUD trade weighted index is 2% lower than in February.

Consequently, despite a significantly lower cash rate profile, the growth and inflation forecasts have been lowered. These current forecasts are what we should call absolute ‘bare-essentials’ – growth slightly below trend (trend at 2.75%) and inflation only holding at the bottom of the 2–3% target band out to the end of the forecast horizon. It seems clear therefore that the RBA now believes that it needs to cut rates to barely achieve an acceptable outcome.

The timing of market pricing is slightly more cautious than Westpac’s forecasts (announced on February 21) of cash rate cuts in August and November 2019.

The reasonable issue therefore arises as to whether these cuts should not occur immediately. In that regard, we need to point to the lingering theme which the RBA has promoted for most of 2019. That theme relates to the “tension” between the labour market data and economic growth as depicted through the national accounts and partial indicators particularly around retail sales and the housing market.

In the introduction to this SMP, the RBA notes “in contrast to the signal coming from the national accounts, a number of labour market indicators remain positive. Employment growth was strong in the March quarter… the vacancy rate remains high and there are ongoing reports of skilled shortages”. However, the RBA’s own forecasts do not envisage the unemployment rate falling further until 2021, even with the rate cuts embedded in the forecasts.

Consequently, there remains  a suspicion that their labour market forecasts might prove to be pessimistic and, if so, the favourable dynamics that would be associated with a much stronger labour market could be expected to develop. Those dynamics would be associated with faster wages growth, faster employment growth, faster growth in household incomes, faster consumption growth;  a narrowing in the output gap, and therefore a more favourable profile for inflation. Given that the Bank must realise that it is nearing the floor of the cash rate a time to assess this prospect is reasonable.

The issue therefore becomes one of what data around the labour market will be required for the RBA to delay its rate cuts. That theme is fully emphasised in the final sentence in the introduction to the May SMP, “the Board will be paying close attention to developments in the labour market at its upcoming meetings”.

It has been Westpac’s view for some time that the unemployment rate has already bottomed out at 4.9% and we expect that it will gradually drift up through the second half of 2019 to around 5.4%. We expect that trend to become clearly apparent by the June employment report (released in late July), making the first cut an obvious decision for the August meeting. There is always a risk that such a trend could emerge more quickly, but, given the volatility of the monthly employment reports, and the “strong employment growth in the March quarter”, we would be surprised if the RBA was prepared to abandon that hope at an earlier Board meeting.

We are not surprised that the RBA has now adopted our own view of the consumer with its big reduction in forecast consumer spending growth to 2% in 2019 now broadly in line with our own. The RBA is also moving towards our forecast for the contraction for dwelling investment in 2019 of 9%, having now forecast -6.7% from -4.5%, and an overall reduction in the GNE forecast from 2.6% to 1.9% (Westpac’s forecast is 1.6%).

Conclusion

Today’s SMP emphasises that the RBA thinks it’s highly likely that it will need to follow market pricing with two rate cuts. Westpac concurs with the market’s August timing for the first cut but expects that the second cut will occur in November – well before the timing implied by market pricing of a full cut by May 2020.

The risk remains that the RBA may choose to move earlier than August, although given the strong first quarter for employment growth and the notorious volatility of the monthly employment reports, it seems likely that a prudent central bank would wait until August for its first move – when of course it will be able to fully explain the move and support it with its revised forecasts in the next Statement on Monetary Policy.

June for me, no point waiting now.

Comments

  1. Fingers crossed. I put cash down betting on it the other day.

    Odds have changed.
    I got in at 2.85 & 31
    Now 2.1 and 41

    • No chance of a cut in June. In the last thirty years they have only ever adjusted rates twice in June, and that was only after they had also adjusted the month before in May. Not gonna happen.

  2. proofreadersMEMBER

    Salad days for private banksters? – pesky RC swept under the carpet, zero funding costs on the way (but beware of bank run because of very hot money book), mortgage rates dropped so stressed loans reclassified as pristine, loosening prudential from APRA, credit pushed out the door again to anyone with a pulse etc etc. Memo note: Book that first class trip.

  3. DominicMEMBER

    Currently this debate is like arguing over whether the blue deck chairs should be arranged in front of the grey deck chairs (or vice versa) on the Titanic.

    Seriously, the timing is irrelevant. It’s gunna happen – just do it. Pretending there’s some science or vast intellect involved in this decision is hubris on a grand scale.

    • Lol and even more pointless now that the titanic has already made contact with iceberg. The crash already baked in.
      People still talking like iceberg is miles away and the way they deal with these minor decisions affect the outcome in any way.

  4. Why wait. If you think you need to go then you probably do and you don’t want to be driving in the rear view mirror when you’ve got limited capacity to cut. Cut now and cut hard

    • proofreadersMEMBER

      Yep. Put this undeservedly-lucky country to the death – the sooner, the better.

    • No ability to cut hard is an issue. Last time cut hard was i think over 400bps. Now there’s not much left. So you get “cut hard and cut soft”. What does that do?

  5. He’ll wait until August. The CPI issued in July will be informative but also by then the new Government of whatever stripe will have its feet under the desk and not only will he have a clearer view of whatever fiscal changes (allowing for lags) he will have to deal with, but everyone else will as well.