We expect the RBA to cut the cash rate by 25bp to 1.25% on 4 June 2019. A further rate cut looks probable and we think that it will most likely arrive at the August Board meeting. The risk is that a second rate cut arrives later than August. We believe that the probability of the cash rate going below 1.0% is very low.
Monetary policy has been unchanged in Australia since August 2016. But today the RBA moved to an explicit easing bias. Governor Philip Lowe today stated that, “at our meeting in two weeks’ time, we will consider the case for lower interest rates.”
The RBA are reluctant rate cutters. We have known that for some time. Indeed the cash rate has not been lowered under Governor Philip Lowe. However, persistently below target inflation, below trend GDP growth and a slight rise in the unemployment rate mean that policy easing now looks imminent.
We had long been of the view that a cash rate of 1.5% would be the low point of the cycle. And financial market pricing was broadly consistent with this view until late‑2018. Since then, markets have increasingly priced in rate cuts even though the RBA has had a neutral bias since February 2019 (recall that the RBA had a tightening bias throughout 2018).
The pricing towards rate cuts reflects a softening in the Australian economy. Consumer spending has slowed, which has weighed on overall GDP. Dwelling price falls have continued and the flow of credit has been trending down. The long anticipated decline in residential construction is underway. Business confidence has eased. And there are concerns around the global economic outlook, notwithstanding the recent monetary and fiscal easing in China.
However, despite some of the weakening in the data, we believed that the RBA would keep the policy rate on hold because of the strength in the labour market. Indeed, the labour market remains strong. Employment growth has actually accelerated. And the Governor recognised that today when he noted that, “job creation has been strong”.
But strong employment growth alone looks insufficient to fend off rate cuts. The reasons are two‑fold and relate to developments that we didn’t anticipate. We believe that the RBA wasn’t expecting them either.
First, Q1 2019 CPI printed materially below expectations. The weak inflation read took the annual rate of both underlying and headline inflation further below the 2‑3% target band. As a result, the RBA was forced to downgrade their profile for underlying inflation in the May Statement on Monetary Policy (SMP). This lowered the hurdle for a rate cut.
Second, despite strong employment growth, the seasonally adjusted unemployment rate has inched higher for two consecutive months because participation has risen. Underemployment has also risen which means that spare capacity in the labour market has lifted. This makes it harder to generate the desired lift in wages and inflation.
It is the combination of these two events that we think will see the RBA cut the cash rate when the Board next meets on 4 June. The weak Q1 2019 CPI on its own was insufficient for the RBA to cut in May. But the lift in the unemployment rate to 5.2% in last week’s employment report sealed the deal. As did the following paragraph in today’s Minutes:
“Members noted that the central forecast scenario was based on the usual technical assumption that the cash rate followed the path implied by market pricing, which suggested interest rates were expected to be lower over the next six months. This implied that, without an easing in monetary policy over the next six months, growth and inflation outcomes would be expected to be less favourable than the central scenario.”
In effect, the RBA has made it explicitly clear that to achieve their inflation and growth forecasts they will need to cut the cash rate by around 50bp. And given their inflation forecasts only put core inflation at 1¾%/yr at Q4 2019 and 2%/yr at Q4 2020 the RBA is implying that monetary policy easing is required to meet their inflation target (note that while this technical assumption normally appears in the SMP forecast table it is the first time it has been mentioned in the Minutes).
As such, we now favour a June rate cut followed by another rate cut in August. The risk is that a second rate cut arrives later than August because of impending tax relief and recent developments related to the housing market (see below).
As we flagged in a note last week, personal income tax rebates will flow to around 10 million low‑to‑middle income earners from as early as mid‑July 2019. In total, the Australian household sector will receive around $A7½ billion in rebates over 2019/20 (equivalent to 0.6 per cent of disposable income or two 25bp interest rate cuts). A similar amount will be refunded to households in 2020/21.
We believe that the economic impact of the tax cuts may be similar to the $A900 ‘cash splash’ by the Rudd Government in 2009. That is, we expect to see consumer spending, particularly on discretionary items, increase materially over Q3 19 with some spill‑over into Q4 19. That, in combination with monetary policy stimulus, means that GDP growth over H2 2019 should step up.
Today, however, we received news that it is “very unlikely” that Parliament will sit before 30 June 2019 which means that the full tax cut may be delayed until legislated. Tax rebates of around $A3½bn from the May 2018 Budget have been legislated. But the “top up” announced in the April 2019 Budget has not. It slightly clouds the picture as to the exact timing around when households will receive the full tax rebate. But in any event, tax relief is coming.
The negative wealth effect is about to wane
Consumer spending softened over H2 2018 and the early part of 2019 in part because of falling house prices (otherwise known as the wealth effect). Indeed the RBA Governor delivered a speech on this very topic back in March (see here). We believe that expected RBA interest rate cuts coupled with two key developments related to the housing market over the past four days will see house prices stabilise over coming months. This is turn means that the headwind from falling dwelling prices on household consumption will wane.
Rate cuts on their own would probably have been enough to see dwelling prices bottom out. But today APRA announced proposes amending guidance on mortgage lending. More specifically, APRA has proposed removing its guidance that Authorised Deposit‑taking Institutions (ADIs) should assess whether borrowers can afford their repayment obligations using a minimum interest rate of at least 7%. Instead, ADIs would be permitted to review and set their own minimum interest rate floor for use in serviceability assessments. In effect, this means that any lowering in mortgage rates could be expected to have a greater impact on credit growth than otherwise. Today, Governor Lowe stated that, “the APRA move is complementary to monetary policy, not a substitute”.
The other development is the “unexpected” election outcome over the weekend. The reinstatement of the Coalition Government means that the uncertainty of Labor’s proposed changes to negative gearing and the capital gains tax have been removed. This is likely to generate higher lending growth to investors than otherwise.
Governor Philip Lower reminded us today that monetary policy is not the only option. He stated that, “in the event that the unemployment rate does not move lower with current policy settings, there are a number of options. These include: further monetary easing; additional fiscal support, including through spending on infrastructure; and structural policies that support firms expanding, investing and employing people. Relying on just one type of policy has limitations, so each of these is worth thinking about.”
The economy is about to receive stimulus from a variety of forms: lower interest rates, tax relief, a lift in infrastructure spending and we believe a stabilisation in dwelling prices. In addition, the AUD sits a bit under $US0.69 which, according to the RBA model, is 10% undervalued.
The Australian economy remains in good health. Forthcoming stimulus, particularly to the household sector, should see confidence lift and in turn spending and economic activity.
On February 21 Westpac forecast that the Reserve Bank would cut the cash rate by 50 basis points in two tranches – August and November. Since then markets and forecasters have largely moved in that direction.
We have not changed that forecast since that date.
However, today, we are announcing an adjustment to the forecast to bring forward the first cut to the June Board meeting with the second cut to follow in August.
We then expect the cash rate to remain on hold through 2020.
This change in forecast reflects the lift in the unemployment rate for April from 5.1% to 5.2% and the confirmation from the Governor that the Board would be closely following developments in the labour market with the primary focus on the unemployment rate.
The Governor’s thinking has evolved over the year to accept that, as we have observed in other countries, upside inflation risks are consistent with a lower unemployment rate than had previously been assessed. For Australia the Bank had believed that the key unemployment rate was 5% – he now accepts that he can drive the economy harder with an associated lower unemployment rate without risking any inflation overshoot.
Recall that the current forecast for the unemployment rate is 5% to end 2020, (falling to 4.75% by June 2021), based on market pricing, which in the May Board Minutes is assessed as “the cash rate was expected to be lowered by 25 basis points within the next three months and again by the end of 2019”.
In his speech “the Economic Outlook and Monetary Policy”, released today, he gives the strong guidance that “at our meeting in two weeks’ time, we will consider the case for lower rates”.
Recall that other aspects of the Bank’s current forecasts are underwhelming despite the assumption around lower rates – 2.6% growth in 2019; 1.75% trimmed mean inflation in 2019; and 5% unemployment rate by end 2019.
With the June rate cut virtually locked in the issue is why we expect a follow up move in August.
Firstly, that timing is a little more aggressive than was used in the May SOMP and therefore could reasonably be associated with somewhat more optimistic forecasts.
Secondly, we expect that the June quarter trimmed mean inflation print (released on July 31) will be 0.4% indicating that underlying inflation will print 0.7% for the first half of 2019, making it difficult to persist with a 1.75% forecast for underlying inflation in 2019 – downgrading the underlying inflation forecast to 1.5% in 2019 will make it difficult for the RBA to credibly forecast a return to 2% inflation in 2020. The Bank may choose to persist with overly optimistic forecasts but will need to ease again to emphasise its inflation targeting credentials.
This second cut would also be consistent with the assumptions that have underpinned the May forecasts .
Key to Westpac’s rate cut forecast on February 21 was the expectation that the unemployment rate was likely to reach 5.4% by end 2019. Our work around the weakness in the cyclical parts of the labour market ( around 60% of employment) which is already apparent and recent trends in the business surveys signal that the softening in the labour market can be expected to become more apparent in the next few months.
We also expect that the March quarter GDP report (released June 5) will confirm the Bank’s recent downbeat assessment of the consumer ( consumer spending growth in 2019 revised down from 2.5% in February to 2.0% in May) and note that the May Minutes see downside risks to the consumption forecasts.
Note also that the May Minutes point to downside risks for the global economy and confirmed in today’s speech.
Looking further out it is important that the Governor stressed the importance of the exchange rate in the monetary policy transmission mechanism. Accordingly, in order to extract ongoing “dividend” from the rate cut cycle it seems likely that the August RBA decision will not preclude further action.
However, our current assessment is that with the housing market stabilising in 2020 and the RBA uncertain about the impact of sub 1% cash rate on the economy the eventual low point in the cycle will prove to be 1%. This view is consistent with our original call back in February this year.
Our forecast low point of USD0.68 for the AUD which printed in our report on February 21 was predicated on the two cuts – the change in the timing of the cuts does not materially affect that call.
I’ll stick with June and July. Why wait?