RBA can't sit on its hands forever

With declining real wages and a likely softening in inflationary pressures, the easing cycle has further to run.

The Reserve Bank of Australia (RBA) left rates unchanged at its July board meeting and, consistent with recent months, indicated that they will remain that way for some time yet. But with household spending slowing and Chinese authorities looking to ease excess capacity in their steel sector, the RBA faces a massive challenge to keep the economy on track before mining investment collapses.

The cash rate remained at 2.5 per cent in July, the tenth consecutive month without a rate move, but with each passing month there is mounting evidence that the RBA may need to do a little more to boost the non-mining sector and provide relief for Australian households.

Much could depend on the inflation outlook, which for now remains fairly benign. The RBA notes that “inflation is expected to be consistent with the 2 -3 per cent target over the next two years”. That’s a firm tick for leaving policy unchanged but there remains some considerable downside for inflation.

With a subdued labour market and declining real wages, the current inflationary cycle could peak in June at around 3 per cent before softening noticeably over the remainder of the year. It is hard to see prices on non-tradeable goods presenting a challenge when wage pressures are non-existent.

Furthermore, the recent rise in inflation on tradeable goods will quickly dissipate if the dollar doesn’t depreciate further. In that regard, the exchange rate provides both an upside and downside risk to the inflation outlook; however, the RBA has indicated that inflation could remain within the band even if the dollar depreciates further.

At present, inflation is likely to be sufficiently subdued that the RBA could lower rates further without a risk of exacerbating inflation pressures.

The exchange rate itself remains stubbornly high, particularly given the sharp fall in iron ore prices. So far, an elevated dollar is “offering less assistance than it might in achieving balanced growth in the economy”.

The RBA made little mention of household spending in the July statement. That is unfortunate, since the outlook for consumption has deteriorated noticeably over the past few months.

With a subdued labour market and consumer sentiment near recessionary levels, it is difficult to see household spending bouncing back in the near term. Add in declining real wages and budget cuts and it could become downright messy.

Dwelling price growth has moderated somewhat recently, while building approvals have declined sharply over the past three months. Housing construction picked up in the March quarter and should support the Australian economy over the next couple of years but is unlikely to boost growth significantly.

The biggest near-term challenge for the Australian economy is the anticipated collapse in mining investment. The RBA noted that there were “signs of improvement in investment intentions in some other sectors”, but said these plans remain tentative as firms wait for conditions to improve.

Much of the risk to investment lies on the downside, particularly with China slowing and the iron ore price falling sharply. Chinese authorities are looking to ease excess capacity and “smaller increases in … exports are likely in coming quarters”. Low prices may result in delays or even cancellations of the few remaining mining projects that are expected to go ahead.

In addition, the longer the Australian dollar remains elevated, the more likely firms in the non-mining sector are to delay investment. The next capex survey, released in late August, will provide crucial insight into investment behaviour and could provide the trigger that will shift the RBA’s view on the economy.

The RBA may have maintained its neutral stance but we need to get used to the idea that the easing cycle has further to run. A noticeable slowdown in consumer demand, budget cuts and a sharp decline in mining investment points to an economy that will continue to struggle over the next couple of years. As a result, I expect the RBA to lower rates before the year is out.

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