Next Monday we will see the Reserve Bank governor's semi-annual appearance before the House of Representative's Standing Committee on Economics. His opening statement will provide an opportunity for a more detailed justification for this week's rate cut. We will be particularly interested in how he deals with the stronger-than-expected boost to spending on investment goods.
Some commentators argue that the details in this week's national accounts make it less likely that we will see a swift follow up to this week's move.
We take the contrary view.
The interest rate-sensitive parts of the economy – consumers, housing, and retail/hospitality – all slowed more sharply than expected. In growth terms that was partly offset by a surge in plant and equipment investment, most likely dominated by the mining industry. This surge in investment and business expectations is likely to cause the bank to raise its economic growth forecast.
The governor may actually give this revised forecast in his statement. However, markets should not interpret that as a sign that rate cuts are being shelved.
If growth is being dominated by mining investment – an industry that employs directly only 1 per cent of workers and adds little to domestic demand pressures – then risks to inflation are hardly raised, as excessive weakness in labour intensive household spending and housing will take the required pressure off price pressures. In short, the market should not be spooked if the governor raises his growth forecasts due to stronger business investment.
As expected the Reserve Bank cut rates by 25 basis points following its board meeting on September 2. We had originally expected the cut to be 50 basis points but lowered that call to 25 basis points when we saw the extraordinary results from the survey of capital expenditure plans which was released on August 28.
With the outlook for business investment sharply higher than the market or the bank had expected the cautious approach of only cutting by 0.25 per cent seemed more appropriate.
The importance of that survey and the 10 per cent rise in plant and equipment investment in the June quarter was emphasised in the governor’s statement, where the most significant change to the rhetoric of the previous statement was the observation that "fixed investment by businesses continues to be very strong”.
The surprise from the capex data stands in contrast with the 17 year lows in most business confidence surveys and the collapse in business credit growth (three month annualised growth pace has slowed from 21 per cent a year ago to 4.5 per cent). In recognition of that sharp contrast the governor refers to "a softening in business activity” in another part of the statement.
Last month we forecast that this easing cycle would be different to previous cycles. In the last two easing cycles rates were reduced by 225 (2001) and 250 (1996-97) basis points within a year. In this cycle we expect there to be a 'pause' in the cycle after the first 100 basis points of easing. That 'pause' is likely to occur from around February/March next year.
The bank’s plan will be to hold demand growth at a reasonable 2-3 per cent pace for an extended period to generate sufficient excess capacity to move underlying inflation back to within the 2–3 per cent target band by end 2010 from its current formidable 4.5 per cent.
With official cash rates at 6.25 per cent and bank mortgage rates 50 basis points higher than 'normal' due to the higher wholesale funding costs associated with the credit crisis, financial conditions will still be contractionary and should gradually deliver the desired result on inflation.
Of course, contractionary financial conditions should not be maintained once inflation pressures appear to easing significantly and the bank should be able to move conditions towards neutral and into the expansionary zone during the course of 2010. We would expect another 100 basis points of rate cuts through 2010.
The next move in the cycle (another 25 basis point cut) is expected to follow the bank’s board meeting on October 7. Evidence from the national accounts which were released for the June quarter add to the case for another move.
The accounts showed that household expenditure contracted for the first time in a quarter since 1993. Tight financial conditions and high energy prices have severely constrained consumers. The case to ease financial conditions for consumers and those businesses which are not benefiting directly from the commodity boom is very strong. The only growth in the June quarter was delivered by a 10 per cent increase in plant and equipment investment. That stems directly from a 13 per cent increase in the terms of trade and an associated 12 per cent jump in profits. In contrast, household incomes only rose by 2 per cent.
It is tempting to conclude that the investment boom is confined to the mining sector. However the capex survey indicated the investment surge was more widely distributed. Our analysis of the survey indicates that mining investment (28 per cent of capex) is expected to be boosted by 45 per cent in 2008/09 while services investment (55 per cent of capex) is expected to rise by 23 per cent in nominal terms.
Overall, the capex survey points to a 29 per cent increase in investment in 2008/09. That would see the Reserve Bank’s targeted below-trend growth profile impossible to achieve without an unprecedented contraction in consumer spending. That will not happen, but equally we strongly doubt the reliability of the capex signal. Capacity constraints are likely to severely restrict the mining plans and tighter lending restrictions and funding costs are likely to hamper the service sector's plans, compounded by a deteriorating outlook for sales as consumer spending remains lack lustre.
Current investment expectations for a number of domestically focussed industries – finance (12 per cent growth), retail (15 per cent), telecommunications (22 per cent), wholesale trade (19 per cent) – are all expected to be revised down. Indeed, if the collapse in business credit growth is a reliable lead indicator we may see similar downward revisions to those in the early 1990’s when the capex survey proved to be unreliable.
Booming mining investment might make the aggregate GDP numbers look respectable but the employment multiplier (mining is only 1 per cent of direct employment) effect of the mining industry is unlikely to soothe the RBA’s concerns if consumer spending and housing continue to show the extraordinary weakness of the first half of 2008.
It is likely that the RBA will raise its headline growth numbers but remain just as concerned about the damage to the Australian economy of overly tight financial conditions.
Bill Evans is chief economist at Westpac Banking Corporation