Via Bill Evans at Westpac:
As expected, the Reserve Bank Board decided to lower the cash rate by 25bps to 1.25%.
This action is very much in line with Westpac’s forecast first set out on February 21, although it comes two months earlier than our original timeline.
The basis for the RBA decision was “to support employment growth and provide greater confidence that inflation will be consistent with the medium-term target”. The major dynamic in that regard is to push harder on the unemployment rate to try to reach the point where wages growth lifts markedly.
The Governor has left open the prospect of further action, noting that “the Board will continue to monitor developments in the labour market closely and adjust monetary policy to support sustainable growth in the economy and the achievement of the inflation target over time”.
Regular readers will be aware that Westpac expects further cuts in this cycle in August and November.
Developments since the RBA rate cut on Tuesday June 4 have provided us with further confidence that our forecast for three rate cuts in 2019 will prove accurate.
Firstly, the Governor has pointed to an ambitious objective for the labour market, with an unemployment rate of 4.5% seen as necessary to bring inflation back to target. This is despite his own forecasts indicating a 5% result on the basis of two rate cuts. That challenge can certainly be interpreted as an expectation of the need to deliver more than just two rate cuts.
Our earlier discussion on May 24 around our target cash rate of 0.75% emphasised downside risks to the cash rate, but noted the difficulties in lowering the cash rate below 0.5% and providing some pass through to the general economy – except for the impact on the currency.
We concluded that 0.5% could be the lower bound for the cash rate, although we are comfortable with our 0.75% target. The Governor considered international precedents and referred to the 0.25-0.50% seen in the US, UK and Canada, but did not indicate whether the same level would be effective for Australia.
The other significant development since the RBA meeting has been the disappointing GDP report for the March quarter. This again highlighted the key themes that have been most prominent in our consistent assessment that the Australian economy is likely to continue operating well below potential, namely weak household income growth, a cautious consumer and a turning point in the savings rate.
The report showed that GDP growth was only 0.4% in the March quarter and is likely to trigger a further downward revision to the RBA’s 2019 GDP forecast.
Westpac has consistently forecast around 2.2% for GDP growth in 2019, while the RBA has recently lowered its forecast from 3% in February to 2.75% in May (2.6% to 1 decimal point), with a likely further downward revision in August.
We have also argued that it will be difficult to retain the 1.75% underlying inflation forecast for 2019 by August when, as we expect, the June quarter underlying CPI will print 0.4% for a total of 0.7% for the first half of the year. We think it will be important that when the RBA addresses these lower forecasts, it responds with a further rate cut in August and another one to follow in November.
There has been some speculation that the RBA may cut earlier in July. This is not our central view given the likely need to respond to these downward revisions in August.
Turning to the US, we have revised our federal funds rate profile to include two cuts of 25bps in September and December this year.
A key influence on this assessment is that a new variable has entered the US economic model – one labelled “political unpredictability”.
This variable is certain to have a negative coefficient on any equation describing US investment decisions and general confidence. We believe that it is now so embedded in US business behaviour that even resolutions of the current trade controversies are unlikely to convince businesses that the coast is clear.
We expect the FOMC will be assessing current risks in a similar fashion, revising down central growth views, particularly around business investment and confidence, and widening the uncertainty bands around these views. Chair Powell has recently pivoted from his previous “patient” stance to one where he is prepared to act and it is likely that the FOMC are seeing this variable as part of their risk assessment.
At this stage, we are not franking market pricing by extending the rate cuts into 2020 as we expect some reasonable resolutions to the current crises to prevent a ‘worst case’ scenario, particularly for the US consumer.
Failure to resolve these issues would lead to a considerable shock to household disposable income and household demand. That development, of course, would require further action from the FOMC than we are currently forecasting.
In 2020, with the consumer remaining in reasonable shape, we would also expect the housing market, which has currently stabilised, to respond to this lower profile for interest rates.
With markets currently pricing in more extensive cuts than we are forecasting, we see little scope for further declines in US yields in 2019, and anticipate that they will rise modestly through 2020.
Given that markets are still not fully pricing in our RBA view by the end of 2019 and are more aggressive on the profile for federal funds rate cuts, we are comfortable to retain our central forecast that the AUD drifts down to USD 0.66, albeit reaching that level in the first half of 2020 rather than late 2019.
Revised forecasts for key variables appear in the forecast table at the end of this document with full detail made available in our June Market Outlook (to be released June 11).
Given unemployment is about to start rising through H2, the RBA will have to a lot more than two cuts to get the labour market back to a 4.5% UE rate. Indeed, even it succeeded, wages still won’t rise owing to the mass immigration economic model so this argument can basically be extended in perpetuity to QE then ‘helicopter money’.
Moreover, if the US is cutting rates owing to “political risk” around the trade war, what does that make little Australia as it is crushed between the US and China?
Political risk so gigantic that you can now place the Aussie economy firmly in the “emerging market” category.