Via Bill Evans at Westpac:
Last week Westpac moved forward its forecast for RBA cash rate cuts from the original forecast on February 21 of cuts in August and November to cuts in June; August and November.
Therefore, Westpac is now forecasting three cuts in 2019 to push the cash rate from 1.5% to 0.75% and to hold at that level through 2020.
Our forecasts for employment; wages growth; economic growth; inflation and conditions in the housing market are consistent with the need for policy to ease through the full course of 2019, not to go on hold as early as August.
We see the unemployment rate drifting up to 5.4% by year’s end; economic growth at 2.2% for 2019; underlying inflation at 1.4%; and the housing market, while approaching stability, still not in the sort of recovery mode that would cause the RBA concern.
Our research around the housing market indicates that affordability in the major markets is still stretched and any immediate transition to a strong recovery in prices would risk the losses for investors which followed the interest cut related surge through 2016 and 2017.
Further improvements in affordability are required. While all of the lift in affordability through 2018 and 2019 has been through falling prices further progress will largely now come from rate cuts. But progress in affordability will still be required largely discounting the prospect of another price surge.
That means that the June and August cuts should be supported by a further cut in November.
An option which we considered was a move to some form of Quantitative Easing (QE) should the RBA see the need to ease policy further beyond the 1% level. However, consideration of the RBA’s own research on the deposit structure of major banks (see below) indicates that the RBA could be expected to anticipate that the policy transmission mechanism will still have some effect at a cash rate below 1%.
2019 also seems somewhat early to expect the RBA to embrace QE. Central banks have always favoured interest rate policy over QE until they believed that rate policy flexibility had passed or further lowering rates would be ineffective. Central banks have also mainly favoured QE to ease credit conditions rather than boosting demand.
Looking into 2020 we expect that the case for policy easing could still be apparent but as rates go lower and time passes the option to use QE will become more attractive. Arguably the RBA may see our current forecast of 0.75% as the base or possibly as low as 0.5%. Beyond 0.5% QE seems to be the more effective policy if further easing was required.
Consequently our central forecast for the terminal cash rate in this cycle is 0.75% with risks to the downside, although we would certainly see 0.5% as the floor for the cash rate, with QE a more effective policy tool thereafter.
Optimism that further easing in 2020 may not be necessary would be based on the expected stabilisation of the housing market, as rates rather than prices support the further improvement in affordability; a sustained boost to confidence from a stable Federal government which would be in a position to embrace genuine reform; an improving fiscal position as the terms of trade hold up much better than assumed in the Budget estimates; and a more settled global environment as trade tensions are finally settled.
The revised terminal cash rate has implications for our AUD and fixed rate forecasts. While back in February we expected the low in the AUD to be USD 0.68 we have now shaved that forecast back to USD 0.66 by end 2019. This forecast is also predicated on our constructive view on commodity prices and a steady US federal funds rate over 2019.
Markets are currently pricing in a terminal cash rate of around 0.85% by June next year so we have marginally shaved back our bond and swap rate forecasts to reflect a lower and earlier bottom in the cash rate than priced into the market at the time of the meeting in May.
Key to our decision to bring forward the forecasts of rate cuts that we released in February was a speech delivered by Governor Lowe on May 21 when he commented, “A lower cash rate would support employment growth and bring forward the time when inflation is consistent with the target. Given this assessment, at our meeting in two weeks’ time, we will consider the case for lower interest rates”. We expect that he will confirm this view in his Statement following the June meeting aiming to leave the door wide open for lower rates.
However there was a fundamental change in the Governor’s approach. Whereas most of his time as Governor has been marked by an overriding concern with the risks posed to the economy around excessive household debt and frothy housing markets he has now turned his attention to the unemployment rate and labour markets. That is why our “stabilisation” view on the housing outlook is important for our rate profile.
In his speech the Governor turned to another part of his overall objective – the unemployment rate. He noted “ my judgement of the accumulating evidence is that the Australian economy can support an unemployment rate of below 5% without raising inflation concerns”. A lower unemployment rate is also supportive of the “welfare” objective, a possibility of boosting wages growth and assisting with the achievement of the inflation target.
However the RBA’s current forecasts do not inspire confidence that the unemployment rate will fall much below 5%. The current forecasts have the unemployment rate holding at 5% out to the end of 2020. It is important to note that those forecasts are based on market pricing at the time of the May Board meeting which the Board (May Board Minutes) notes as “Cash rate can be expected to be lowered by 25 basis points within the next three months and again by the end of 2019”. The forecast is also based on the AUD holding steady at USD 0.70.
With our forecast that the cash rate will be lowered by 25 basis points on June 4 and August 6 the boost to the economy from rate cuts can be expected to be somewhat stronger than if they are delayed as expected in the RBA’s forecast. Furthermore, the RBA forecast assumes that the AUD holds at USD 0.70 for the duration of the forecast period whereas the current trajectory (spot already below USD0.69) can be expected to be lower.
A key issue is whether a lower cash rate will fail to ease financial conditions due to its very low level? The issue here revolves around the RBA’s expectation of the capacity of the banks to pass on lower rates. Of paramount importance is the structure of banks’ funding arrangements. The RBA has produced a graph in the May Statement on Monetary Policy (Graph 3.6). Our estimate of the numbers in the graph is that: 8% of banks’ deposits are held at 0% interest rate; 25% between 0% and 1%; 15% between 1% and 1.5%; 42% above 1.5% and 10% in offset accounts (effectively earning the mortgage rate). On these numbers the RBA would assess that around 90% of banks’ deposits could cope with the 0.5% rate cut, already expected.
Arguably, on these numbers, around 75% would cope with a further cut. These numbers are approximate and, no doubt, do not cover all issues.
Without doubt the option of QE would be on the radar screen for the RBA but, given the analysis of banks’ deposit structures, it is reasonable that they would look to lower rates in the first instance. At some level of the cash rate, perhaps 0.75% but certainly 0.5%, it is likely that the transmission mechanism from QE would be more effective in easing credit conditions and boosting demand.
The most likely forms of QE would include the RBA purchasing asset backed securities issued by the non-banks or providing attractive funding for the banks secured against their securitised portfolios of mortgages aimed at supporting existing borrowers and possibly tied to new lending targets. Note that the RBA already holds 1.7 million mortgages, 25% of the value of all residential mortgages, on behalf of the banks to support the $243 billion CLF liquidity facility. This facility could be added to; drawn down for long periods at attractive rates; to support a huge liquidity boost to the banking system.
These policies may well be needed to help the RBA move towards its key objectives but are more likely issues for 2020 rather than the immediate challenges which are faced in 2019.
