WEEKEND ECONOMIST: All smoke, no signal

Markets have moved to effectively price out prospects for any more rate cuts in Australia. We believe such action is misplaced. Consider the results from the June quarter national accounts.  The report highlighted that growth in the Australian economy is slowing down. This is not only due to the peaking of expenditure in the mining sector, but also the lack of response of domestic demand, specifically consumer spending and non-mining business investment to the 225 basis points of rate cuts that the Reserve Bank has delivered since November 2011.  

A high Australian dollar and tight fiscal policy are leaning against lower rates, exacerbating efforts by the monetary authorities to redistribute growth. Growth in domestic final demand has slowed from 6 per cent in the year to June 2012 to 0.6% in the year to June 2013. Annual growth even slowed sharply in the last quarter, from 1.35 per cent in the March quarter to 0.6 per cent in the June quarter.

This is the slowest annual growth rate since 2009 when domestic demand contracted in the aftermath of the Global Financial Crisis.  Major contributors to this slowdown were consumer spending, with annual growth of 1.8 per cent (slowest since 2009) compared to annual growth in the year to the June quarter 2012 of 3.5 per cent.

Evidence of the cautious consumer is also apparent from the further increase in the savings rate, from 10.5 per cent to 10.8 per cent in the quarter.  Annual growth in investment in new machinery and equipment has slowed to –7.5%, compared to 4.1% only a year ago. That slowdown is partly explained by a slowdown in mining investment in plant and equipment, although the abrupt slowdown in mining investment is best highlighted by the slowdown in new engineering construction, from 55 per cent a year ago to 1 per cent in the year to June 2013.

 While markets took some comfort from the fact that economists'  forecasts for the June quarter were slightly more pessimistic than the final result (0.5 per cent growth an outcome of 0.6 per cent), that seemed to be a somewhat overdone response given that the data confirmed the RBA's really downbeat assessment of the Australian economy in  2013 (2.25 per cent growth).  That slowdown in growth momentum in Australia is also apparent for the US economy.

For the year to June 2013, real consumer spending growth slowed from 2.3 per cent in the year to June 2012 to 1.8 per cent in the year to June 2013. That is despite strength in sales of durables (12 per cent of consumption; dominated by motor vehicles), which has been boosted by easy credit. Durables growth of 7.8 per cent in the year to June 2012 held at 7.7 per cent in 2013.

On the other hand, growth in services (66 per cent of consumption) slowed from 1.9 per cent in 2012 to 1 per cent in 2013. That slowdown in consumer spending is broadly explained by a slowdown in income growth. Annual growth in nominal disposable  income is 2.2 per cent year-over-year to July 2013, versus 2.7 per cent a year ago  (July 2012).  Real disposable income is up a meagre 0.8 per cent for the year to July 2013, versus 1.2 per cent a year ago. For the last three months, the average monthly pace is 0.3 per cent annualised.

The story around business investment is underwhelming. Annual growth in business investment has slowed from 9 per cent in the year to June 2012 to 2.3 per cent in the year to June 2013. Of course, there has been a well-publicised sustained boost to dwelling investment, which grew 14.8 per cent in the year to June 2013, up from 11.6 per cent in the previous year. However, note that dwelling investment is only around 3 per cent of GDP, compared to services consumption of around 45 per cent.

The significance of the housing recovery can be expected to be seen through employment and the wealth effect on confidence, incomes and spending. To date there appears to be very limited signs of that channel working. In June 2011, the employment to population ratio reached a low of 58.2 per cent and now stands at 58.7 per cent. During that time, the unemployment rate has fallen from 9.1 per cent to 7.4 per cent.

Clearly, the fall in the unemployment rate has been largely due to a falling participation rate. Evidence of the ongoing slack in the labour market comes from the 0.1 per cent fall in average hourly earnings over the  year to July.  This 'snapshot' highlights that superficial excitement with partial  indicators like the Institute for Supply Management's Non-Manufacturing Index and house prices (limited evidence of  wealth effect on spending behaviour) can create a falsely over-optimistic assessment of the state of the US economy.  It also casts some considerable doubt around the movement in market pricing in Australia, which is now pricing out any rate cuts in Australia due to the impact on the curve of heightened expectations of Federal Reserve tapering and rate hikes.

 A reasoned assessment of the US economy, which seems likely to be the approach of the Fed, would find market movements — including an increase in long bond rates from 1.7 per cent to 3.0 per cent since  April, and implied pricing that the Fed will start raising rates by  June 2014 — as quite startling. Implications for the housing market, business investment, and mortgage refinancing are significant.  

The decision on the timing and size of "tapering" will be impacted by the data flow, specifically the August non-farm payrolls.  However, if the Fed feels obliged to offer some modest tapering  ($US5 billion to $US10 billion) due to issues around market stability, it may also see a need to discourage speculation of a premature rate hike.

The fragile economy will not cope well with this ongoing tightening of financial conditions.  It may be time for the Fed to recognise explicitly that the unemployment rate has not been a reliable measure of the state of  the US labour market due to falls in participation (the discouraged worker effect). Accordingly, the announcement of a modest tapering might be linked with stronger guidance around the 6.5 per cent unemployment trigger. That guidance might vary from lowering  the trigger to a range, say 5.5–6 per cent, or emphasising to the market  that the current unemployment rate is not the best measure of  the state of the labour market, with more reliable measures like the employment to population ratio being more indicative of future policy.  Such policy action is likely to significantly settle interest rate markets, including Australia, potentially restoring market pricing around the probability of further rate cuts to more sensible levels.