The Reserve Bank board meets next Tuesday and for the third consecutive month it is almost certain to decide to hold the cash rate steady at 3.5 per cent.
Our view has been, and remains, that there is scope to cut rates later in the year probably beginning in November with a 25 basis point cut to be followed by further cuts in December and in the first quarter of 2013.
However, the trigger will be different to that which snapped the RBA out of its denial phase earlier in the year. Recall that markets confidently expected a rate cut in February but the RBA did not oblige arguing that growth was at trend; the unemployment rate was near full employment and inflation was well contained – a desirable combination for a central bank and, despite rates being in the contractionary zone, not one requiring any policy response.
The print of the 2011 fourth quarter GDP jolted that complacency. Growth in the December quarter was reported at 0.4 per cent for annual growth of just 2.3 per cent. We estimated at the time that the RBA was expecting a print of around 1 per cent so this came as quite a shock and rate cuts resumed shortly thereafter with a surprise 50 basis points in May followed by a further 25 basis points in June.
The Australian Bureau of Statistics is set to release the GDP print for the June quarter on September 6, one day after the board meeting. We do not expect such a disappointing growth story for the June quarter.
Real retail sales have already been reported to have increased by 1.4 per cent providing a very solid base for the contribution to growth of consumer spending. Of course that turbo-charged consumer can be significantly attributed to the $1.9 billion in government fiscal payments which were distributed in May and June. Indeed nominal retail sales chalked up an 11 per cent annualised growth pace in May and June.
We estimate that consumer spending in the second quarter will increase by 1 per cent following the 1.6 per cent increase in the first quarter.
The other big contributor to GDP growth in the June quarter is expected to be net exports which, at this stage, we estimate will contribute 0.8 percentage points to growth, boosted by a 5 per cent increase in exports, where the strength is expected to be broadly based.
Recall that over the four previous quarters exports grew a total of only 6 per cent, compared to this 5 per cent in one quarter. That contribution of 0.8 percentage points contrasts with a subtraction of 0.5 percentage points in the first quarter.
Other aspects of the report will be less impressive. Housing construction is set to contract by around 2 per cent, the fifth consecutive quarter of contraction. Overall business investment is likely to be soft with mining-related infrastructure investment registering a flat result following a 20 per cent surge in the first quarter.
However the headline quarterly growth number is expected to come in at 0.8 per cent with annual growth of 3.5 per cent certainly confirming the RBA's assessment of a 'trend' growth pace.
Consequently, the events of the first half of the year cannot be relied upon to source a new series of rate cuts.
For the domestic economy the issues will revolve around an expected sharp loss of momentum in consumer spending. That is likely to reflect the 'one-off' nature of the factors behind the strong momentum in the first half of the year. Much of the strength in real spending in the first quarter was due to aggressive price discounting while fiscal payments boosted spending in the second quarter. Fiscal consolidation at both federal and state levels is now likely to impact consumer spending through the second half of 2012 and into 2013.
Signals from the Westpac-Melbourne Institute Index of Consumer Sentiment certainly point in that direction. The index has now been below 100 for the last six months having taken a surprising drop of 2.5 per cent in August. To date we have no spending data for the September quarter although, in line with the sentiment report, recent business surveys point to a sharp drop in retail business conditions in July. Retail sales for July will print next week and will provide some early evidence on this issue.
The second major domestic factor for rates will be around the unemployment rate. The labour market has been soft. Employment growth over the last year has been only 0.6 per cent. Full time employment growth has been 0.3 per cent. However the unemployment rate has only risen slightly, from 5.13 per cent in July last year to 5.23 per cent in July 2012.
The rate has been held down by a fall in the participation rate from 65.6 per cent in July last year to 65.2 per cent. If the participation had held steady, the same jobs growth would have seen the unemployment rate up around 5.8 per cent by now. Indeed the employment to population ratio has fallen from 62.3 per cent to 61.8 per cent.
This fall in the participation rate and particular weakness in full time jobs is reflecting the structural change in the economy as full time jobs are being lost in manufacturing, construction and finance and not being adequately replaced in the growth areas – mining and health and education services.
Our analysis of the job separation rate – the pace at which jobs are being lost – indicates that labour shedding is picking up while the rate of new hiring (as indicated by job ad surveys, business hiring intentions and vacancy rates) is likely to slow after largely offsetting the pick-up in labour shedding to date.
Evidence of nervousness around the job separation rate is clear from the Westpac Melbourne Institute Indicator of Unemployment Expectations where respondents have shown (apart from the 2008/09 period) the highest degree of concern since the early 1990s (Chart 1).
Our reading of the Reserve Bank is that it would have patience with an unemployment rate up to 5.5 per cent but anything higher would require some measure of policy response. Employment reports over the course of this year will be critical for interest rates. Our forecast remains for an unemployment rate of around 5.75 per cent by year's end.
Next week's employment report will be important in this regard. While interest rates have come down, that easing in financial conditions has been partially offset by the currency. Australia's terms of trade have fallen by around 11 per cent over the last nine months while the Australian dollar has actually risen by around 3 per cent in trade weighted terms.
A credible explanation for this disconnect is the structural increase in holdings of Australian dollar assets by foreign investors, particularly central banks, as they seek to diversify reserve assets away from euros and US dollars (Chart 2). This insensitivity of the Australian dollar to a sharp fall in the terms of trade would be noticed by the RBA which has attributed currency flexibility as a shock absorber for the Australian economy. In turn such a development potentially puts more pressure on interest rate policy.
With rates only 50 basis points below the Reserve Bank's neutral a respectable case for lower rates should be made entirely from the perspective of the domestic economy.
However, markets, which are pricing in a 100 per cent probability of two 25 basis point cuts by year's end are relying on global developments.
In that regard it is reasonable to expect that the RBA has been surprised by the pace and extent of the slowdown in China. The latest print from the HSBC PMI which saw a fall from 49.3 to 47.8 would have surprised it just as it surprised the market. As our China observer, Phat Dragon noted, "the headline fell to 47.8 from 49.3 and the orders and inventory detail was unambiguously weak. The survey is describing a pronounced inventory overhang that will take some months to clear. And the employment index betrays the fact that job market dislocation – a key trigger for policy easing – is underway in the export industries: and also perhaps in heavy industry itself."
We remain of the view that there is enough encouragement from other, less high profile releases, to expect eventual stability and modest recovery in China but we expect that the RBA's Chinese views will have been shaken recently.
Short term risks for the iron ore price to shoot markedly below our long held forecast of $100 are clearly to the downside as this inventory correction works through. However we remain of the view that iron ore prices will enter an up-phase through 2013 supported by a recovery in Chinese demand as inventories clear; stimulus policies are intensified; and global liquidity is aggressively boosted by the US Fed (QE3) and the ECB.
While we do not expect the current collapse in coal and iron ore prices to be sustained through 2013, the value of coal and iron ore projects in the 'committed' or 'under consideration' categories is just not sufficient to fill the impending gap which is likely to be created by the slowdown in gas projects (Chart 3) forcing Australia to look elsewhere for a new source of growth beyond the middle of the current decade. With current mining projects underway costed around $225 billion being dominated by gas projects ($180 billion) uncertainties around future gas pricing arrangements are likely to significantly reduce prospects of another wave of new gas projects which could sustain growth in investment spending as current gas projects wind down from 2014.
Finally, we come to Europe and the market's conviction that something spectacular might be on the cards. No doubt ECB President Mario Draghi's pronouncements and subsequent actions which are likely to be at least partially outlined next week dominate the market's attention. But a seismic shift in Europe is extremely unlikely to occur. Europe is not the dominant reason behind our rate call.
Generally Draghi will do as much as he can to deliver on his stability promises subject to a binding German constraint and being mindful that confidence in the future of European stability must be maintained. A loss of confidence might trigger an unstoppable torrent of outflowing capital from the periphery that would quickly overwhelm Germany's pain threshold. For example, a Greek exit which would unsettle markets would not be allowed for fear of unleashing that capital outflow. Bank deposits in Greece have already fallen by around 40 per cent and they are now contracting in Spain (Chart 4).
Europe is very important for our global growth view. To date we are expecting Europe to contract by 0.7 per cent in 2012 to be followed by a more modest 0.2 per cent contraction in 2013. That improvement will be underpinned by ECB stimulus; a more competitive euro; some easing in 'austerity' and, optimistically, social harmony in the periphery.
Such a slight improvement coupled with an improvement in China's growth profile in 2013 from 7.8 per cent in 2012 to 8.7 per cent in 2013 is expected to see a turnaround in the impact on global growth from the 'Big 3' – the US, Europe and China – from a drag of 0.5 percentage points in 2012 to a boost of 0.3 percentage points in 2013. That provides a multiplier effect and will form a base for a solid growth improvement outside the 'Big 3' (53 per cent of global GDP) – economies that are generally export oriented with reasonable scope for domestic stimulus – adding a further 0.7 percentage points.
However, if Europe disappoints and does not assist with that turnaround, the growth recovery in 2013 from 2.9 per cent in 2012 to 3.7 per cent in 2013 would be much more muted.
Bill Evans is Westpac's chief economist.
THE WEEKEND ECONOMIST: Home-grown hiccups
There is enough evidence on just the domestic economic scene to be sure of a November or December rate cut, or two. Indeed, China and Europe considerations will not be as decisive as many think.
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