The Reserve Bank board meets next week on December 6. Westpac has consistently argued that the current easing cycle, which began on November 1 with a 25bp rate cut, will total around 100bps in rate cuts over its course.
On November 15 the Reserve Bank released the minutes of the November 1 meeting. Our analysis at the time was that there was considerable concern with respect to economic and financial developments in Europe and the potential impacts on the rest of the world, particularly Asia.
The RBA’s opinion on the domestic economy had cooled significantly from earlier in the year and this was highlighted in significant reductions in their forecasts for economic growth and inflation over the forecast period which were released in the Statement on Monetary Policy on November 5.
Westpac's own growth forecasts are lower for 2011 but broadly in line with the RBA's forecast for 2012 and 2013.
At the time, we concluded that the minutes indicated there was scope for further rate cuts particularly with the Bank forecasting that underlying inflation would remain comfortably within the 2–3 per cent band for both 2012 and 2013. However we concluded that there was insufficient evidence to change our call that the next rate cut would be in February.
We emphasised that the decision on whether to bring the rate cut forward to December would depend on developments overseas, particularly in Europe and Asia. Previous rate cut cycles have always featured an immediate follow-up move but these have all begun from a much higher level with rates starting clearly in the contractionary zone.
The Bank has assessed that the current setting of rates is around neutral so the decision to cut immediately after the first move is tougher. Indeed, in a speech to the Australian Business Economists on November 24 the governor emphasised the importance of waiting when formulating policy.
Any decision by the Bank to cut further in December will therefore be a finely balanced issue. The board will be required to weigh its assessment of global developments against the fact that rates are close to neutral.
Our assessment is that conditions have deteriorated significantly in Europe and Asia since the last board meeting on November 1.
Consider the following evidence:
Through November we have seen increasing acceptance by both private and public forecasters that Europe will be in recession in 2012. Over the last few weeks little headway has been made in Europe despite the many headlines.
Most worrying has been the rise in Italian bond yields – over the past month, the 10-year yield has risen from 6.09 per cent at the end of October to 6.70 per cent on November 14 then jumped over 7.00 per cent this week and has been trading in a range of 6.64 per cent to 7.24 per cent over the past fortnight. A 10-year Italian yield of 6 per cent is typically regarded as the key level beyond which the long-term sustainability of Italy's debt burden is more questionable.
The European periphery’s plight, and the impact this may have on Germany, has also seen the German 10-year yield rise by around 50bps in the past month to 2.28 per cent; this month also saw an uncharacteristically weak bid-cover ratio at a 10-year bund auction, indicating wavering investor demand for debt securities of even the strongest EU member.
In contrast, one-year bund yields have gone negative as investors seek low risk assets. The rise in periphery yields has been driven by concerns over the political and economic status quo and weak reads for European industrial production and a number of confidence measures.
With the markets becoming increasingly concerned over the ability (and/or will) of the authorities to find a solution, sentiment was further dented by comments that the EFSF may not be able to be leverage as much as first thought.
We were also interested to note a fairly downbeat assessment of Europe from the governor during the Q-and-A session following the speech on November 24. The governor thought that the situation in Europe was "dire but not serious, as the old joke goes”. He thought Europe was "fast coming to the point where all the parties who have a role to play in getting to the solution there really have to hurry up and do it, otherwise the probability of damage to ... everyone will be unacceptably high.”
Notwithstanding the above, there has been a significant improvement in risk appetite over the last few days as a number of the world’s major central banks took action to increase liquidity in the financial sector to provide a buffer to global commercial banks from the financial problems in the eurozone.
This action will by no means fix the problem in Europe, but it should provide some breathing space while the authorities work towards a durable solution. However, the very fact the authorities deemed this action necessary highlights the depth of concern in the region.
In Asia, we have seen further evidence of a regional slowdown. The final release of the November HSBC manufacturing PMI (seasonally adjusted by the issuer), came in at 47.7, versus 51.0 in October and the second half average of 50.1.
The sharp fall of the headline index was concentrated in output and new orders. The official Chinese manufacturing PMI deteriorated in November to 49.0 (not seasonally adjusted); the detail was weak with orders down and inventories up. At the same time, steel and iron ore prices have started falling again. Since November 15, iron ore prices in China have fallen 10 per cent while inventories of ore have risen more than 5 per cent through November. The past month has also seen growth slow in India, third-quarter annual GDP growth was 6.9 per cent annually, from 7.7 per cent in the second quarter.
While the outcome was 'as expected', it highlights that activity in India has been decelerating. Given the stance of policy and global developments, there is little reason to believe the growth pace will not deteriorate further in the fourth quarter.
Recent PMI outcomes for the rest of the region have also been consistent with the thesis of a regional slowdown being underway. The governor made comments on Asia in his recent Q-and-A, and in particular that the transmission of a bad outcome in Europe to Asia would come through not just the trade side but via the finance channel.
In his opinion, "financial conditions are tightening for trading countries right now because of the difficulties that some key European banks who do a lot of trade financing have had in funding.” And in regards to the outlook for China given European difficulties, the governor thought the answer was in "how much scope a country like China has to move in an expansionary direction” which will depend on "how successfully they feel they've dealt with the inflation threat”.
Offsetting some of this has been a more positive tone to the US data of late. While third-quarter GDP and house prices came in under expectations, we did see better than expected October housing permits and starts, existing home sales and durable goods orders. The various regional business surveys have been mixed but, overall, in the last two weeks of November there has been a more positive tone to the US data.
On the domestic front the data is not particularly strong, in our view. The governor used the term "OK” to describe recent domestic data.
The ‘two speed’ or ‘patchwork economy’ is still very much in play. Both business and consumer confidence have been boosted by the first rate cut, although we expect that such gains are unlikely to be sustained over the next few months without further rate relief.
At the heart of the debate has been the mining investment boom which has clearly gathered momentum over the last year. Elsewhere, investment has been patchy, with non-mining investment broadly flat in the year to the June quarter (our calculations), although a lift in spending appears evident during the September quarter.
Standing out in the official third-quarter capex survey was the 22 per cent ($3.1 billion) rise in mining investment – lifting annual growth to 60 per cent, up from 30 per cent a year ago. However, the direct benefit to Australian production is significantly less, with much of this investment sourced from imports.
In the year to June, total business investment added 1.6 percentage points to annual demand growth but the boost to GDP growth was a smaller 0.7 percentage points after accounting for the leakage to capital imports.
We now expect that GDP growth in the September quarter will print around 1.3 per cent, providing some support to the Bank's near term growth forecast. However the interest rate sensitive parts of the economy continue to struggle with dwelling approvals; house prices and credit growth remaining lack lustre.
The unemployment rate has increased from 4.9 per cent to 5.2 per cent and the leading indicators suggest that unemployment is set to rise further albeit at a relatively slow pace. The broader trends can be contrasted with a housing sector that continues to look very weak.
While most of the data still pre-dates the November rate cut, there have been no signs of stabilisation in house prices across most capital cities. Indeed, some corrections are now becoming quite advanced.
A particular standout this week was the very weak October dwelling approvals which contracted by 10.7 per cent in the month including a 7.5 per cent drop in private houses. These figures do point to a greater degree of urgency for RBA action. Clearly there will be a significantly weaker profile in housing construction than we had thought; a 5 to 10 per cent decline could take about 0.3 to 0.5 percentage points off GDP.
From the consumer side, the retail numbers were slightly under expectations but not decisively so given the noise in the data.
The picture painted by the data to October suggests a relatively resilient profile for spending and even some firming in cyclical spend, although the level remains weak and the recovery in growth is likely to lose momentum.
In short, the board's decision next week will be a tough one.
It will depend upon the degree of urgency with which it assesses the global developments weighed against the policy stance already being around neutral; the inherent attraction of waiting to assess global developments; some promising evidence of acceleration in mining investment contrasted with weakness in the housing sector.
While we are generally comfortable with forecasts over the medium term of the likely policy response, no forecaster can feel at ease trying to weigh up the value judgements of the board on a month-to-month basis.
On those really tricky occasions like the current one, experience dictates that the best approach is to forecast what you think should be the most appropriate policy response. On this occasion we think the best policy would be to cut by a further 25bps – thereby bringing forward our forecast profile of moves of 25bps in February, May and August to December, February and May.
We adopt this forecast while at the same time emphasising that the key point is the need for a further 75bps in cuts with the final move still coming around the middle of 2012.
Bill Evans is Westpac's chief economist.