The Reserve Bank board meets next week on April 5. There is virtually no chance of a decision to change rates at that meeting.
In his February testimony before the House of Reps Standing Committee on Economics, RBA governor Glenn Stevens clearly indicated he saw policy as "ahead of the game". The key dynamic driving the Bank's thinking is the ongoing need to ensure there is sufficient available capacity in the economy to accommodate the mining boom. The most important measures of that capacity will be the labour market, wage pressures and underlying inflation. We expect the news on underlying inflation from the CPI report (due April 28) to remain benign with annual core inflation printing in the low '2s'. However the dynamics of the labour market remain more problematic for the Bank. One key issue is just how important the mining industry has become as an indirect employer. In a recent speech, RBA assistant governor Philip Lowe attributed much of the recent strength in employment to industries that are servicing mining.
In the discussion below we set out our views on the other major force which is currently impacting the Australian economy – the cautious consumer. We conclude that this behaviour is likely to be sustained for some time. How those industries which directly service the household sector adjust their employment plans to a sustained period of consumer caution will impact the employment outlook and the RBA's rate decisions. It is too early for the RBA to make that assessment and with inflation low, the board has time to fully assess the situation.
We are maintaining our call (held since last November) that only one rate hike can be expected this year and not before the September quarter. A change in the employment outlook, which still looks strong on the basis of the leading indicators, would be the key to any change in that view. We expect the RBA sees it in the same way and has time to test its employment thesis.
Why is the consumer cautious?
Regular readers will be aware of Westpac's consistently less hawkish views on the interest rate outlook relative to other commentators and, from time to time, the market. At present the market is more dovish than Westpac, expecting rates are more likely to fall than rise in the near term – a somewhat absurd notion in our view.
Looking back to around a year ago, Westpac was forecasting the RBA cash rate to reach 4.75 per cent by March 2011 from 4 per cent in March 2010. Market surveys at the time had other commentators in the 5.25 per cent to 5.5 per cent forecast range.
Our thinking was very much based around our observations of the cautious consumer. We never denied the sustainability of the mining boom and the strains it would impose on capacity but we saw consistently soft consumer spending and its associated impact on the housing market as being likely to ease the pressure on capacity by enough to allow the mining boom to proceed without the need for drastically higher interest rates.
The Reserve Bank was also in the hawkish camp through most of 2010. In its Statement on Monetary Policy in November, commentary on the theme of the cautious consumer was couched in terms of an upside risk to the economy (i.e. if caution eases). In its Statement in February the RBA widened this to include caution could as a downside risk as well – after another three months of data, the Bank appeared more prepared to accept that the changes we were witnessing in consumer behaviour might be more 'structural' than had originally been assessed.
The structural/cyclical debate about consumer caution goes to the heart of the policy debate. No one can credibly deny the sustainability of the mining boom. The crucial issue is therefore whether consumer spending/housing will remain subdued enough to continue providing spare capacity to accommodate the mining boom without requiring a more heavy handed approach to monetary policy from the RBA.
The manifestation of the cautious consumer is probably most neatly captured in the sudden rise in the household savings rate. We see a range of factors behind this.
Firstly, part of the rise must be attributed to the 'scare' consumers experienced in 2008-09 as a sustained period of high interest rates was followed by the spectacular unravelling of the global financial crisis. By mid 2009 households' confidence in their job prospects had plummeted to the lowest levels seen since the Westpac-Melbourne Institute started measuring 'Unemployment Expectations' in the 1970s. Consumer Sentiment itself was also near record lows. With house prices falling, job security questionable, and a wide range of media and other commentators, including the RBA governor, predicting a recession, consumers would have been ruing the previous 10 years when debt was accumulated primarily to finance house purchases but also, directly and indirectly, to finance current spending with savings rates pushing into negative and mortgages treated increasingly as a source of liquidity rather than a debt to be paid down.
Of course since that time consumers have become decidedly more comfortable about their job security but they have remained unsettled about their finances. The chart below shows an index of the two components of the Consumer Sentiment Index that measure how consumers feel about their own finances. Note how these components did not recover as strongly as the overall index and are now only marginally above 2009 levels. The other three components of the Consumer Sentiment Index (measuring consumers' outlook for the economy over the next 1 and 5 years; and whether they see now as a good time to but a major household item) are much more robust.
We suspect that consumers accept that the mining boom will be positive for the overall economy but question its direct benefit for them. They may also be assessing that now is a good time to be purchasing a major household item due to the high Australian dollar but do not actually plan to do so due their dismal assessment of their own finances.
Market pricing has also worked to increase the attractiveness of saving. Banks are now paying 100-200 basis points above the bank bill rate on retail deposits compared to 100 basis points below bills prior to the global financial crisis. This is a direct result of a perceived need to lower reliance on more volatile wholesale deposits including those from foreign lenders. Banks remain alert to the risks of over-reliance on wholesale funding – a reliance that has in the past been reflected in Australia's persistently large current deficits (which, indirectly, is also due to an insufficient pool of domestic savings, particularly from Australian households).
There may be other more cyclical reasons behind the sharp increase in Australia's household savings rate. As time passes and interest rates do not increase at the pace currently expected by households, we may see a modest relaxation of consumer caution.
However, this is likely to be met with higher interest rates as the Reserve Bank seeks to restrain domestic demand in order to accommodate the mining boom. We expect one 25 basis point move from the Bank in the third quarter with further rate hikes in 2012.
A sustained relaxation and an associated return to rising house prices, stronger credit growth, and a consumer much more confident in their finances is unlikely without further balance sheet consolidation. That takes time and brings with it the risk of further weakness for consumer demand and the housing market.
Bill Evans is chief economist at Westpac.