The challenge ahead for the RBA

The Reserve Bank of Australia (RBA) left rates unchanged at the June board meeting and continues to indicate that they will remain that way for some time. But with household spending slowing and the construction boom more myth than reality, the RBA faces a massive challenge to keep the economy on track before mining investment collapses.

The cash rate was held at 2.5 per cent in June, the ninth consecutive month without a rate move, and based on the RBA’s inflation outlook it is implied that rates could be left unchanged for a couple of years.

The RBA notes that “inflation is expected to be consistent with the 2-3 per cent target over the next two years”. With a subdued labour market and declining real wages, inflation on non-tradeable goods is likely to remain contained for some time.

The exchange rate does pose some upside risk, though the RBA believes that inflation could remain within the band even if the dollar depreciates. The RBA noted that the exchange rate “remains high by historical standards, particularly given the further decline in commodity prices.”

My view is that annual inflation will tip a little over 3 per cent in the June quarter – which requires inflation growth of at least 0.5 per cent – but the pick-up will be temporary. A sustained period of high inflation is unlikely with wages so low.

But if the exchange rate does push inflation higher, it would be a small price to pay if it helps boost the non-mining sector and facilitate the rebalancing of the Australian economy. The RBA would be misguided if it tries to mitigate foreign drivers of inflation, particularly since any attempt to do so will likely be met with failure.

Dwelling prices moderated somewhat in May – even accounting for some seasonality – while building approvals have declined rapidly over the past three months (Don’t dwell on the myth of a housing construction boom; June 2). 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 comes in the form of mining investment collapsing. In that regard, there was good news last week with the capex survey showing that investment in the non-mining sector appears to be stronger than anticipated (Some good news amid Australia’s capex decline; May 29).

But there remains considerable uncertainty surrounding the outlook for investment as “firms wait for more evidence of improved conditions before committing to significant expansion”. In my opinion, most of the risk to business investment lies on the downside, particularly with China slowing and the iron ore price falling sharply.

The RBA expects government spending to be subdued. The federal budget was poorly received and then disastrously sold, but so far neither I nor the RBA have any idea what effect this has had on spending. The main impact has been seen through measures of consumer confidence, which began to plummet the moment that budget details were leaked.

Export growth has been exceptionally strong and is set to contribute around 1.4 percentage points to March quarter growth. This has been driven by resource exports as new production has come online; however, the RBA expects that export growth will be somewhat weaker in the quarters ahead. Combined with soft consumption, investment and government spending and we are looking at a fairly disappointing June quarter outcome.

As I noted earlier today, the rebalancing of the Australian economy has been built on three pillars: consumption, residential investment and exports. I comprehensively dismantled the belief that residential construction could drive growth yesterday and today consumption is looking decidedly shaky (A bad time for households to tighten their purse strings; June 3).

It has been almost taken for granted that the next move for the RBA will be up. But we may have to get used to the idea that the cutting cycle has further to run. With negative real wages, a high unemployment rate and slowing consumption, the economy may get weaker before it successfully rebalances.

For the RBA, the big question is whether the current cash rate can keep the non-mining sector up and running while mining investment collapses. Based on recent data, I suspect that there are a few economists pacing Martin Place right now who have their doubts.