Weekend Economist: Dollar reversal

Despite the Reserve Bank's new plan to pressure the dollar, an uncertain growth outlook and far-off Fed tapering could see the board cut rates early next year.

As expected, the Reserve Bank board decided to hold the cash rate steady at 2.50 per cent in December.

The governor's statement was virtually identical to the November statement with only two changes. The first of these related to the assessment of the inflation outlook where wages were added to prices as pointing to contained inflation pressures. We think that the soft wage outcome (2.5 per cent year on year) for the September quarter was particularly welcome to the Reserve Bank, indicating that non-tradable inflation pressures are likely to ease from this point. The other change related to the assessment of recent strength across housing and equity markets and appears less significant.

The main event in a crowded data calendar this week was the release of the third-quarter national accounts. It showed growth in the Australian economy slowed from 2.4 per cent in the June quarter to 2.3 per cent in the September quarter. There was very little in the accounts to support optimism about the economy.

Firstly, consumer spending growth dropped to 0.4 per cent in the quarter for 1.8 per cent through the year, markedly below trend of around 3.5 per cent year on year. While retail sales picked up modestly (up 0.7 per cent for the quarter), services spending growth slowed further for a particularly weak 1.2 per cent through the year.

One bright spot was a 2 per cent lift in disposable incomes, but this appears to be due to one-off boosts to non-labour income and from lower interest rates, with labour income only up 0.6 per cent for the quarter. Furthermore, households remain cautious since the benefits of the disposable income lift showed up in a 1 percentage point jump in the household savings rate to 11.1 per cent – the highest since June 2012.

The contribution from housing construction was disappointing, 
with new dwelling investment lifting only 0.2 per cent for the quarter and annual
 growth dropping from 8 per cent to 4.6 per cent. The strong rise in dwelling approvals between September and October points to better gains ahead, although the high concentration of 'units' in the rise means it is more susceptible to sharp reversals than a more broadly based gain. Also, activity remains weak in the renovation sector. Indeed, total housing investment actually contracted 0.5 per cent in the third quarter due to a 1.5 per cent for the quarter contraction in renovation activity. This is clearly related to the ongoing caution of Australian households.

The national accounts showed a 1.1 per cent pick-up in total new business investment, but the critical equipment component (a reasonable proxy for non-mining investment) contracted by another 1.1 per cent to be down 9.7 per cent for the year. Engineering lifted by 2.8 per cent but is still down 1.5 per cent for the year, highlighting that the mining investment boom has peaked. The third quarter rise is unlikely to signal a delayed uplift in mining spending.

Overall, domestic demand increased by a modest 0.4 per cent to be up by only 0.9 per cent for the year. These numbers are significantly below trend and indicate that, up to the September quarter, the economy has not been responding satisfactorily to substantial monetary stimulus. Other detail showed: government spending is an ongoing headwind to growth (down 0.2 per cent for the quarter); a marked slowdown in exports (up just 0.3 per cent for the quarter, 6.1 per cent year on year); and inflation under control, with the consumption deflator up 0.7 per cent for the quarter, 2.5 per cent year on year. The GDP estimate was boosted by a 0.7 percentage point contribution from net exports, but this was not driven by a 'healthy' uplift in exports but more a substantial contraction (3.3 per cent) in imports, mainly reflecting a major slowdown in capital imports.

Policy overview

The Reserve Bank has been forecasting 2.25 per cent growth for 2013 so this overall number will not come as a surprise. Year-to-date GDP 
is now up 1.8 per cent, slightly higher than the Reserve Bank may have expected due to an upward revision to second quarter numbers, from 0.6 per cent to 0.7 per cent. The lack of momentum, particularly in domestic demand, is unlikely to prompt the bank to lift its forecast for 2013, and certainly the below trend forecast for 2014 is likely to remain.

The worrying aspects of the third quarter GDP report are that household spending remains very weak despite a solid lift in disposable income this quarter, with households again opting to put extra income towards savings rather than spending. The 'non-labour' source of the income lift also suggests it is a one-off boost rather than the beginning of a sustained period of stronger disposable income growth. There is also little to be encouraged by around business investment, with four quarters in a row now of declining equipment spending and the surprise lift in mining-related engineering investment unlikely to be sustained. Overall, the national accounts emphasise that the Australian economy is likely to require further stimulus in order for growth to lift back towards trend.

Since the November board meeting, a number of developments have been significant. Firstly, the bank lowered its growth forecast for 2014 from 3 per cent (trend) to 2.5 per cent (below trend). However, it retained the view that growth in 2015 would lift to between 2.75 per cent and 4.25 per cent. While the buoyant but uncertain forecast for 2015 (given the wide range) has been retained, it is reasonable to assert that a central bank that is predicting below trend growth one year out and remains confident about containing inflation should be providing more stimulus.

It appears that the additional stimulus is planned to come through a lower currency rather than the conventional channel of lower interest rates. The governor's speech on November 21 raised the possibility of direct intervention, with recent decision statements maintaining the view that the Australian dollar is uncomfortably high and a lower currency would assist in rebalancing growth.

Over the next few months, there will be several developments that will determine whether this strategy is successful. Most important will be the policy actions of the US Federal Reserve. If it engages in a tapering strategy for its quantitative easing program, that is likely to assist the bank's objective of lowering the Australian dollar (although such a move is already largely priced in by financial markets). Our view remains that Fed tapering is not likely until 2015. As such, we see the Australian dollar drifting upwards rather than falling.

In those circumstances, it seems reasonable that the bank will eventually revert to the more conventional method of lowering rates. The timing of those policy actions will also be influenced 
by developments in the housing market, since a key motive for eschewing rate cuts appears to be concern over a potential housing bubble. However, the case for stimulus is likely to become more urgent as the labour market weakens more rapidly than in recent months. For now, our forecast is that the next rate cut may be as soon as the March quarter, with February nominated as the starting date. However, given the range of uncertainties, this timing could easily be delayed.

Bill Evans is Westpac's chief economist

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