Westpac: RBA to hike until “vulnerable borrowers” break

Following the December inflation shocker, I agree that at least two more hikes are a lock. I am doubtful about a third. 

As for a recession or not, it is all but certain in my book.

But then, I am of the view that only per capita growth (or contraction) matters.

Westpac’s Bill Evans below.

The Reserve Bank Board meets next week on February 7.

We expect it is highly likely that the Board will decide to raise the cash rate by 25 basis points while maintaining the guidance used in December for the next meeting on March 7.

On February 10 the Bank will release its February Statement on Monetary Policy where the interest will be in the Bank’s forecasts of inflation, wages and growth.

Consider the wording in the Governor’s statement following the December Board decision to raise the cash rate by 25 basis points. “The Board expects to increase interest rates further over the period ahead, but it is not on a pre-set course. It is closely monitoring the global economy, household spending and wage and price behaviour.”

Developments since that Statement support a rate increase.

With the unexpectedly rapid reopening of China; a mild European winter with associated lower energy prices; and justifiable expectations that the US Federal Reserve is nearing the end of its tightening cycle and as inflation reports continue to be encouraging (including this week’s report showing a further slowing in US wage inflation) there is good cause to be more optimistic about the global economy than at the time of the December Board meeting.

Even the IMF has recognised these developments by raising its forecast growth rate for 2023 from 2.7% to 2.9%.

The latest Retail Trade report showed retail sales fell by 3.9% in December following an upwardly revised 1.7% increase in November.

Note that about half of the retail sales category is food, the rest covering department stores; household goods and clothing.

Retail sales also account for only about a third of overall household consumption.

Also note that the survey figures are ‘seasonally adjusted’.

Unadjusted retail sales still rose in December – by 16% – but not by as much as anticipated by the estimated usual seasonal move: 20%. The challenge here is that the increasing popularity of Black Friday sales in late November is seeing what looks to be a permanent shift in the regular seasonality. This can only beconfirmed over time. Until then, seasonal adjustments will tend to overstate ‘underlying’ strength in November and overstate weakness in December.

It will be instructive to wait for January retail sales estimates to see whether this December effect has been overstated.

It is also important to note that the ABS survey definition of retail sales excludes a wide range of spending, including many segments that might ordinarily be thought of as ‘retail’. It does not cover pubs and bars, hotels and accommodation, motor vehicles, fuel, the bulk of market services including recreational services like cinemas, theme park, telecommunications, and travel and other services including health and education.

The December quarter inflation report provided some evidence of demand conditions in the services sector. The domestic travel and accommodation sector saw prices lifted by 13.3% and by 7.6% for international accommodation and travel.

Our Westpac Card Tracker (which covers credit and debit card turnover across the Westpac Group) suggests wider turnover held up reasonably well in December but with some weakening in spending in retail components offset by a strong surge in non-retail components – travel and recreational services in particular. Note that this is over and above regular seasonal increases around the holiday period.

We expect the RBA Board will be cautious around the December retail print. It will not base its decision on one month’s data, particularly given the issues noted above. It is likely to instead wait to assess seasonal issues and to get a better assessment of wider consumer spending in the December quarter national accounts, which will be available on March 1 just prior to the March Board meeting.

The key issue for the RBA around the inflation story is the surprise increase in the Trimmed Mean measure of inflation.

In November it had forecast that measure to reach 6.5%yr so would be very unsettled by the print of 6.9%yr.

We also noted that annual services inflation had lifted from 3.1% in June to 5.5% in December. Services inflation typically reflects demand and wages growth.

Whereas there is evidence that some supply-side inflation pressures are easing in Australia – along the lines of the US – services inflation is still rising.

While that will partly be about demand, it is also consistent with the idea that Australia’s wages cycle is lagging the US: while wage inflation is easing in the US, wage pressure is still building in Australia.

The Minutes of the December Board meeting noted that the Board discussed options of 50 basis points, 25 basis points and on hold.

In the Governor’s statement, following the meeting, he did not refer to that detailed discussion, so we will not know whether all options were considered on February 7 until the minutes are released. But from here it seems likely that all options will again be on the table.

If we consider the situation facing the Board at the February meeting compared to December, the stand-out is the higherthan-expected measure for underlying inflation and the associated lift in services inflation that aligns with a stronger domestic demand and wages growth environment.

Accordingly, it seems likely that the Governor will maintain his wording from the December Statement: “The Board expects to increase rates further over the period ahead, but it is not on a pre- set course”.

That still provides ample flexibility but makes it clear that the Board is not yet comfortable with its progress in returning inflation to the target range.

The Board will receive updates on wages in the Wage Price Index on February 22 and in the national accounts for the December quarter on March 1.

Westpac expects that after the 25 basis point move in March there will be scope for a pause in April, to await the March quarter inflation report. Another 25 basis point increase in May, in response to a likely 6.5% Trimmed Mean inflation print, will mark the end of the tightening cycle with the cash rate peaking at 3.85%.

As the RBA awaits the June quarter Inflation Report the evidence around inflation; wages; and demand will be sufficient to avoid an August move with rates on hold for the remainder of 2023.

Still Likely to Avoid a Recession in 2023

Despite having a higher trajectory for the cash rate than most other analysts, many of whom also expect a recession, we think the Australian economy will avoid a recession in 2023.

Our central case is for economic stagnation in the second half of the year, although the risks are to the upside.

The key dynamic behind the stagnation is the cumulative impact of a 375 basis point rate increase on the household sector.

But this post-pandemic cycle is different to previous tightening cycles.

Households have accumulated around $270bn in excess savings, around $110bn of which is held in mortgage offset accounts.

The Reserve Bank calculates that the proportion of household disposable income allocated to loan repayments before the tightening cycle will be around the same after the tightening cycle (based on a peak cash rate estimate of 3.6%). That is because higher interest payments will essentially replace the ‘ahead of schedule’ principal repayments households were making a year ago.

In aggregate, the Bank calculates that the median mortgage borrower is currently 20 months ahead on their repayments, although 20% of variable rate borrowers are only 0-3 months ahead.

It will be the vulnerable marginal borrower who has the most difficult period ahead with higher rates.

But note that scheduled principal repayments represent around 50% of total scheduled mortgage repayments. Borrowers and lenders have some flexibility to adjust the principal portion – extending the term of the loan or even moving to interest-only in some instances.

Labour market conditions should also remain broadly supportive. While we expect the unemployment rate to rise during the second half of the year, this is coming from 50-year lows and to a still relatively low level by historical standards.

It is also against a backdrop of accelerating wage growth.

The bottom line is that most households will be in much better shape to maintain incomes than in previous economic slowdowns, again improving their prospects of meeting mortgage repayments and/or refinancing on better terms.

While these forces will undoubtedly see a significant slowdown in household spending, the legacies of record low unemployment and accumulated excess savings mean the economy is unlikely to lapse into recession.

RBA forecasts in the Statement on Monetary Policy (SoMP)

The most important aspect of the SoMP is the Bank’s revised forecasts, particularly for inflation, growth and the labour market.

These forecasts are based on an interest rate path of the average of market economist forecasts and market pricing.

For the November Statement on Monetary Policy the Bank forecast GDP growth of 1.4% in 2023 compared to Westpac’s forecast of 1%. Both forecasts do not envisage a recession, while anticipating a significant slowdown, and as stated, there are reasons to see upside risks to the Westpac forecast. It seems unlikely that the Bank will make a significant change to the growth profile.

The areas of most interest will be inflation and wages.

The RBA’s November SoMP had wage growth forecast to lift to 3.9% in 2023. Westpac has 4.5%, partly reflecting 3.6% pace at end 2022, which compares to 3.1% for the RBA. The September quarter Wage Price Index printed higher than the RBA had anticipated in November leading to a likely lift in their 2022 forecast.

The wages growth profile for 2023 is likely to be lifted in theSoMP, potentially to around 4.2%.

When we saw the RBA’s 2023 forecast for 4.7% inflation in the November SoMP we were concerned that this showed a lack of urgency about returning inflation to the 2–3% target.

Our own forecast of 3.9% includes a much larger deflationary pulse from supply-side factors in 2023 (including lower fuel prices – the RBA’s convention is to assume flat oil prices in its forecasts). Having observed the encouraging supply-side developments in the US (already affecting fuel, food, energy, goods, and building costs) it is reasonable that RBA will be able to lower its inflation forecast despite lifting the wages profile.

A revision in the headline inflation number to 4.5% in 2023 seems reasonable.

Conclusion

The disturbing inflation report is likely to be the key driver of the decision to raise the cash rate in February.

Wages and Inflation will again drive the March decision and a follow-up in May.

But even at those high rates the economy should avoid recession, thanks in large part to the household sector’s strength.