WEEKEND ECONOMIST: All in the timing

Some unusual moderating factors in a largely expansionary tranche of economic data allows room for the cash rate to bottom out at 2.75 per cent. But not just yet.

The Reserve Bank Board next meets on Tuesday. Despite the current easing bias, there is virtually no chance that it will decide to cut rates at this meeting. However, we do expect the governor to maintain language along the lines of the March board minutes: "with inflation likely to remain around the middle of the inflation target, members judged that there would be scope to cut the cash rate further to support demand, should that be necessary".

Markets have settled on a 50 per cent chance of a cut by June and a 100 per cent probability of one cut by October. A month ago markets expected two cuts by October. Extensive media commentary is now pointing to the rate cut cycle being over and the next move being up. We think that the market has got it about right, and retain our view (held since May last year) that the cash rate will bottom out at 2.75 per cent, from the current 3 per cent.

The confident media commentaries would have been encouraged by a recent speech from Deputy Governor Lowe which depicts an expectant central bank indicating its policies are working. He notes, "the initial responses to a loosening in monetary policy would be expected to include stronger asset prices; improved conditions in the housing market; a lift in consumer sentiment; and a lower exchange rate".

After 15 months of rate cuts, we expect that you should be able to add business confidence, mortgage and business lending, credit growth and the unemployment rate to this list. Figures 3 to 5 contrast the response of the economy to the four most recent easing cycles: 2011-12 (175 basis points); 2008-09 (425 basis points); 2001 (200 basis points); and 1996-97 (250 basis points).

The picture indicates that this cycle has clearly underperformed on business confidence; housing finance; house prices; and some measures of the labour market. The argument that there is scope to do more is supported by the historical analysis. In particular, the modest response of house prices indicates that a major concern from central banks around easing too much due to risks with housing bubbles is not apparent in this cycle.

One area where the response in this cycle has been at least 'respectable' has been the recent boost to consumer sentiment. Note also that this response might be fragile. Our research suggests that the recent 10 per cent boost to consumer confidence is likely to have been partly due to an assessment that global economic conditions (particularly around Europe) have improved markedly. Note (see Figure 1) that our measures of 'news heard' indicate that the European crisis in late 2011 had a bigger impact on consumers than the Asian Crisis, 9-11 or the Lehman Brothers collapse. Since the last survey, the news around Cyprus is likely to have unsettled consumers. Despite Cyprus being only 0.2 per cent of the euro region, the implications of uninsured depositors losing part of their savings are profound for European banking stability. This is likely to register with Australia's consumers, and will be emphasised by the 4 per cent fall in the share market over this period.

Looking ahead, the recent comments by the Eurogroup head Jeroen Dijsselbloem pointed to the Cyprus case impacting future bank bailouts. He concluded that shareholders, bondholders and uninsured depositors should help recapitalise banks. Government funds should only be provided as a last resort. Dijsselbloem said that, with more instruments of “bail-in”, the need for direct bank recapitalisation using the European Stability Mechanism will become smaller and smaller.

These comments have much greater significance for the European model than just Cyprus. They signal to all large depositors in banking systems which may require bailouts (or even enter into discussions with European authorities) that risks have just been ramped up. Risks are no longer restricted to bond holders and equity holders – uninsured depositors now face a totally unexpected and unwanted scenario. The prospects of bank deposits moving from the troubled south to the stable north and destabilising the euro model will have increased substantially, and markets will be watching not only sovereign spreads but also Target 2 balances which measure the degree of that outflow. Recall that Greek bank deposits fell by 40 per cent at the height of their crisis and have not been restored (Figure 2).

In Australia, business confidence remains weak (Figure 3), and has failed to respond to rate cuts while business credit growth has slowed from a 6 per cent annualised momentum in the six months to July to zero in the last six months.

Apparently the data release which gave the bank the most "comfort" was the "capital expenditure data published by the ABS a few weeks back". The report covered the fifth estimate for expenditure in 2012-13, and the first estimate for 2013-14. The degree of precision for the fifth estimate is very high. The degree of precision for the first estimate is notoriously low (for example, a 50 per cent realisation ratio for services investment). The fifth estimate for 2012-13 indicated a breathtaking 30 per cent fall in investment intentions for 2012-13 in manufacturing (revised from a 17 per cent fall in the fourth estimate); a slowdown in growth in mining investment (from 75 per cent in 2011-12 to 10 per cent in 2012-13); and a contraction in services investment of 4 per cent. Taken alone that 'estimate' should have unnerved the bank around the prospects for a boost to investment given that the survey was conducted 15 months after the first rate cut. However, the first estimate for 2013-14, after adjusting for the large realisation ratio, showed a 10 per cent increase in services investment, prompting the deputy governor to conclude "firms expected to increase spending on non-mining investment in the next financial year".

With the poor measures of business confidence and the high degree of variability in the first estimate, it is 'brave' to draw such conclusions in the face of the very poor, and much more reliable, estimates from the fifth estimate for 2012-13. While there is extraordinary uncertainty around the link between the first estimate and the final result, we can compare first estimates across years to assess the overall change in investment sentiment.

Comparing first estimate in 2013 with 2012 showed a fall in mining of 12 per cent; a fall in manufacturing of 24 per cent; and an increase in services investment of 5 per cent. That '5 per cent' compares with an increase in first estimates after previous rate cut cycles of 2.2 per cent (2010); 9.9 per cent (2001); and 28.9 per cent (1998).

As discussed in the deputy governor's speech, there has been no response to the rate cuts from the Australian dollar. When the Reserve Bank started cutting rates on November 1 2011, the Australian dollar stood at $US1.033 and the Trade Weighted Index was 76.6. That compared with the peak level of the Australian dollar against US dollar of $US1.10 in late July 2011, when the TWI printed 78.8. Today the Australian dollar is at $US1.045, and the TWI is 79.4. In short, the Australian dollar has strengthened against the US dollar and especially against the TWI since the rate cuts commenced in 2011. However, the TWI is now at a record level, even higher than when the Australian dollar was at $USD1.10. For this reason, we expect that the Governor will decide to maintain his "easing" bias in the associated statement. Markets will do well to maintain an expectation for lower rates.

Bill Evans is Westpac's chief economist.

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