The outlook for interest rates - up, down or sideways?

Key points

• Raising interest rates in response to the worse than expected June quarter inflation result would be a major mistake. Global uncertainties are high, inflation outside food and fuel is weak and Australian households remain extremely cautious, which is dampening housing demand and retail sales.
• The strong Australian dollar (A$) is another reason for not raising rates. Having broken above US$1.10, the A$ looks like it’s on its way to around US$1.20 to US$1.30.
• Against the backdrop of the mining boom and inflationary pressures on the one hand, but global uncertainty, weak household sentiment and the strong A$ on the other, the most likely outcome is an extended period of rates on hold.

Introduction

For much of last decade, Australia’s outlook wasn’t an issue for investors. It was just steadily motoring along. But unfortunately, over the last year or so, the outlook for Australia has become more uncertain, reflecting a whole range of issues: the resources tax minority government consumer caution excessive house prices poor productivity growth rising inflation, etc. This uncertainty has been reflected in the relative underperformance of Australian shares compared to global shares over the last 18 months. It can also be seen in a divergence of views over the outlook for official interest rates.

The consensus of most economists is the next move will be up. The Reserve Bank of Australia (RBA) (at least until recently) has also been signalling that further monetary tightening is likely to be needed at some point, and the higher than expected June quarter inflation outcome is consistent with this. However, some are saying the next move will be down and this is also priced into the money market (although only just).

Until recently, I too was pretty confident the next move in interest rates was up, albeit I was concerned that getting too aggressive on rates could tip the non-mining part of the economy over the edge. However, despite the June quarter inflation reading, I now think that the outlook for Australian interest rates is finely balanced.

The case for higher rates

The argument that interest rates have further to rise is fairly simple.

• The surge in commodity prices (which make up 70% of Australia’s exports) has pushed the terms of trade to its highest level since the early 1950s. This is resulting in national income and nominal GDP rising at a rate of around 8 to 10% per annum.
• Global growth around its long-term trend of 4% per annum, combined with ongoing rapid industrialisation in China and other emerging countries, will ensure commodity prices remain high going forward.
• Mining investment is set to boom, with investment plans pointing to a 50 to 80% rise this financial year. With mining investment accounting for 4% of GDP, this implies a contribution to GDP growth this financial year of 2 to 3 percentage points.
• Even allowing for the likelihood that a big portion of this will seep into imports, it means the rest of the economy must remain fairly subdued in order for the economy to avoid overheating.
• In the meantime, the trickledown effect of the huge surge in national income from higher commodity prices – via increased employment, the wealth effect from gains in mining share prices, high dividend payments from mining companies etc. – will boost spending elsewhere in the economy.
• Allied to this, the economy is likely to recover from the floods earlier this year as coal production returns to normal and rebuilding kicks in.
• At the same time, with the economy having limited spare capacity – as evident in the unemployment rate having fallen to 4.9% – the mining boom is adding to cost pressures by bidding up wages, with a flow on to city-based industries as key workers relocate to mining areas.
• Consistent with this, inflation is trending higher, with headline inflation running above target at 3.6% and underlying inflation rising to 2.7% from a low of 2.2% in the December quarter. Poor productivity growth and entrenched services sector inflation in government-related areas such as utilities, property rates, health and education suggest the growth/inflation trade-off has deteriorated over the last five years or so.

It is generally thought the logical outworking of all this is that higher interest rates will be necessary to ensure that the non-mining part of the economy makes way for the mining boom, in order to avoid breaching capacity constraints and an overheating in the form of persistently higher inflation and a trade deficit. The consensus amongst economists is for interest rates to rise to a high of 5.5% next year, compared to 4.75% currently.

The counter argument

However, over the last month, several considerations question the view that the next move in interest rates is up.

Firstly, the global outlook has become increasingly uncertain as European debt problems have intensified, the US recovery has proved disappointingly slow and fragile and excessive US public debt has added to the malaise and ongoing uncertainty as to whether China will have a hard or soft landing.

Secondly, the rise in inflation in Australia largely reflects increases in ‘cost of living’ items due to one-offs (for example the continuing effect of the flood on fruit prices earlier this year), the surge in oil prices on the back of tensions in the Middle East and price increases in areas where government plays a key role in price setting (such as utilities, health, education, child care, property rates, motoring charges, child care and postal costs). Outside of these one-offs and non-market influences, inflationary pressures are benign:

• Inflation in market-related goods and services excluding volatile items is running at just 1.8% year on year and
• Inflation excluding fruit and vegetables and petrol is just 2.5% year on year.

Of course there is an argument for a rate rise to help ensure the boost in the cost of living items doesn’t feed through into inflationary pressures, but this is less of an issue if demand in the economy is weak. Moreover, inflation is a lagging variable and the softening in underlying demand seen so far is likely to lead to a softening in underlying inflation over the year ahead.

This brings us to the third point, which is that demand outside of the mining sector certainly is weak. While the impact of the floods early this year is the major reason for disappointing growth in Australia recently, household demand has been much weaker than expected. Retail sales growth has been languishing around 2 to 3% pa. Consumer confidence has fallen to its lowest level since May 2009. Housing approvals, housing finance, house prices and auction clearance rates are all weak. Additionally, employment growth has slowed to a 2% annual pace from nearly 3.5% last year, with job vacancies and other labour market indicators warning of a further softening ahead.

A rise in unemployment is a major risk – Australian companies hired workers en masse last year probably on the assumption that the mining boom mark II would boost overall demand just like mining boom mark I did and they would end up faced with a labour shortage. As this hasn’t happened, the risk is that they may start to lay off some of those workers.

A whole bunch of factors are responsible for household caution including weaker asset prices, tighter credit conditions, post global financial crisis wariness of debt, political uncertainty around the carbon tax, the increase in the cost of necessities and increased online and overseas spending. But the bottom line is Australian households are proving to be far more sensitive to higher interest rates and far more fragile than was expected a year ago.

The logic behind further rate rises was that it would be necessary to keep the non-mining part of the economy subdued so that in the face of the mining boom, the overall economy doesn’t overheat. But if non-mining demand is very weak, the case for a rate rise is substantially weakened.

Finally, it’s worth mentioning the A$. Having now hit a new 29-year high, it looks to be moving even higher on the back of strong commodity prices, continuing high interest rates relative to the US and elsewhere and safe-haven demand as emerging countries are diversifying some of their foreign exchange reserves away from US Treasuries. In fact, right now the A$ is a key beneficiary of the rising risk the US will see its sovereign credit rating downgraded to AA from AAA. By contrast, there is no threat to Australia’s AAA sovereign rating. On the interest rate front, even if the next move in Australian interest rates is down, it’s hard to see this altering the broad direction for the A$. Were Australian interest rates to fall, it would likely be against a backdrop of more quantitative easing in the US which in turn would be bad news for the US dollar.

The past relationship between the A$ and Australia’s terms of trade suggests that the A$ is on its way to around US$1.20 to 1.30.

Australia’s terms of trade points to an even higher A$

Source: RBA, Thomson Reuters, AMP Capital Investors

As such, the strong A$ is likely to continue to act to constrain growth in Australia and bear down on import prices. It’s doubtful this year’s move in the A$ to US$1.10 has fully impacted Australian consumer prices. But if the A$ is going higher, the dampening impact will be even greater. The strong A$ is providing another strong argument for the RBA not to raise interest rates further.

The bottom line

While I think it’s premature to be talking of interest rate cuts, by the same token, arguments for further rate rises have weakened substantially, notwithstanding the worse than expected June quarter inflation figures.

Against the backdrop of the mining boom and inflationary pressures on the one hand, but global uncertainty, weak household demand and the strong A$ on the other, the most likely outcome is an extended period of rates on hold.

Of course, the main risk in the short term is that the RBA may feel compelled to raise rates because it publicly elevated the importance of the June quarter inflation figures in determining the interest rate outlook and they have now come in worse than expected. Against this though, hopefully the RBA will exercise caution given the increase in global and domestic uncertainties.

Dr Shane Oliver
Head of Investment Strategy and Chief Economist
AMP Capital Investors