The final quarter

The RBA retains only 125 basis points in future flexibility. Accordingly we expect that will be conserved for a period when conditions deteriorate sharply and anticipate rates finding a floor in Q4.

Over the last week we changed our forecast for the next RBA Board meeting. At the time markets were close to pricing in a rate cut of 50bps (around 40bps in probability terms) although this probability has now come down to around 100 per cent probability of a 25bp cut – ironically our previous forecast. Below we set out the details of that earlier note.

"We have changed our forecast for the RBA's rate decision on April 7. Westpac had expected that the RBA Board would decide to reduce the overnight cash rate from 3.25 per cent to 3 per cent on April 7. We now expect that the RBA will decide to keep rates on hold at that meeting. We still expect that the lowpoint in the cash rate for this cycle will be 2 per cent but anticipate the Bank taking longer to reach that target.

We have argued in the past that the most efficient policy approach should be to reduce rates as quickly as possible to ensure maximum stimulus for the economy. However the actions by the Board at the March meeting, when it decided to pause despite particularly disturbing data on the Asian economies and a further deterioration in the Australian outlook, indicate that the Bank has decided to take a different tactical approach to these last stages of the easing cycle.

Unlike the US Federal Reserve which despite an effective zero Federal funds rate was still able to adopt the policy of buying Treasuries in order to lower the cost of fixed rate mortgages, the RBA really only has one policy option to influence private sector rates. That is to change the overnight cash rate to directly affect the prime variable mortgage rate.

It appears that the Bank has decided to conserve its flexibility to further influence rates in fear of being in a position of not having any scope to respond to unexpected negative events over the course of 2009 and possibly beyond. It is reasonable for the RBA to assume that a rate cut in response to negative domestic or overseas developments provides some boost to confidence with the knowledge that the RBA is still 'on the case'.

We assess that after cutting aggressively by 400bps in just over five consecutive meetings the Board expects that it has only 125bps at the most in future flexibility. Accordingly we expect that the Board will conserve that flexibility for a period when international and/or domestic conditions deteriorate sharply.

We anticipate that such events remain likely in 2009 and through to 2010 but the period leading up to the next meeting does not fit into that category. On the contrary, confidence in global financial markets has soared with equity markets in particular showing near record increases (recent 2 week surge in the US market is the strongest since 1930's).

We do not think this confidence will be sustained and in particular expect dismal economic data to continue to print for the world economy (my recent trip to China has not convinced me that China is back on a sharp upward trajectory). Australian data will also deteriorate sharply particularly for business investment and employment. For now, however, the Bank will take some confidence from the recovery in new lending for housing, although we would argue that it is too narrowly based relying mainly on the First Home Buyer while investors remain on the sidelines.

A pause to assess the Government's second stimulus package which is currently being implemented also makes some sense. In that regard we would certainly not rule out a continuation of the pause in May. However we maintain the core view that an eventual 2 per cent floor will be reached probably in the fourth quarter." One of the key reasons why the Bank would be careful to retain some flexibility relates to recent forward indicators for the unemployment rate.

On the next page of this note we set out our core forecast for the unemployment rate which we expect to reach near 8 per cent by the end of 2010 while recognising the more disturbing prospects currently being signalled by some of our partial lead indicators for employment growth. Our core view on the unemployment rate is derived from our forecast for domestic demand growth over the course of 2009 and 2010.

That profile envisages a collapse in investment spending not dissimilar to the profiles of the two previous recessions in the early 1980's and early 1990's. Consumer spending is likely to remain subdued due to the constraints on labour income (from rising unemployment) and concerns with repairing damaged household balance sheets. Housing construction will also detract from growth in 2009 although we expect a return to positive growth in residential construction in 2010. That will reflect the extreme current housing shortages, the recent sharp improvement in housing affordability and attractive positive margins which rental yields now enjoy over funding costs in many markets. Overriding this profile will be a very strong contribution to growth from public spending.

Key risks to this dynamic are difficulties for the states (65 per cent of public spending) achieving their spending targets as they deal with budget constraints and rationing of funding for the investment vehicle favoured by residential investors (apartments). Note that approvals for apartments are down by 55 per cent over the last year partly reflecting credit difficulties.

There are, however, more disturbing indicators for unemployment in 2009. The latest Labour Market Composite Index from the Westpac–ACCI Survey of Industrial Trends is indicating a contraction in employment growth of around 2.25 per cent through 2009 compared to our base case of 1.5 per cent. That sharper fall would see the unemployment rate reach towards 8 per cent by the end of 2009 rather than taking until 2010 to reach that level.

Meanwhile the lead from the Unemployment Expectations Index, which is derived from the Westpac MI Consumer Sentiment Index, is pointing to an unemployment rate of above 8.5 per cent by year's end.

Lead Indicators are important tools for economic forecasters but cannot be relied upon for tight point estimates.

The history of Australia's last two recessions shows that in the worst two years of those recessions, the unemployment rate 'only' increased by 2 percentage points each year. These indicators are pointing to 3 percentage points and 3.5 percentage points in 2009 respectively – hardly likely and certainly not Westpac's forecast. However they do emphasise the extreme uncertainty under which economic forecasters (including the Reserve Bank) are currently operating as the world economy confronts its greatest challenges since the 1930's.

From the Bank's perspective better to retain some flexibility to be seen to be dealing with such events rather than expend all flexibility too soon.

Bill Evans is the managing director of economics and research of Westpac

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