The Governor's Statement following the 25 basis point-move in November reintroduced the term 'gradual' (after excluding it from the Governor's October 15 speech and the October Board Minutes). We think the Bank is now firmly committed to the 'gradual' (read 25 basis points) approach until the global economic recovery becomes firmly entrenched.
Our argument has been that the further you are below neutral the lower are the risks to overtightening, so larger moves should be favoured when rates are at their lowest. The alternative view is that around a turning point it is more difficult to be certain that the turning point has been reached so caution is the best approach. While the Australian data is increasingly confirming a turning point, the data associated with the G3 (the US, Japan and Europe) is still far from convincing. The regional and domestic data is pointing to a solid pace of economic recovery – consistent with Westpac's forecasts. However the RBA's growth forecasts (Westpac forecasts 4 per cent growth through 2010 compared to the RBA's 3.25 per cent) are decidedly more subdued and consistent with a "gradual" approach to the tightening cycle.
Caution over the outlook for the G3 economies is certainly not misplaced. While the regional economic outlook is the most important for Australia for exports; investment; and national income (through the terms of trade) the G3 outlook still dominates the state of capital markets; equity markets and, probably, the Australian dollar. Uncertainty over the state of global capital markets affects the outlook for Australia's ability to fund its foreign liabilities and possible wealth and confidence implications from global equity markets. Constraints on lifting levels of offshore funding will feed directly back to the banks' capacity to fund economic growth.
We are sceptical about the pace of recovery in the G3 and therefore expect that the Bank is likely to maintain its 'cautious' 25 basis point tightening process through the first half of 2010. We expect that process to cumulate to a 4.5 per cent cash rate by mid year prior to the Bank going on hold partly in response to ongoing disappointments in the pace of the recovery in the G3 which in turn will manifest itself in ongoing difficult funding conditions and disappointments in equity markets.
Sharp Contrast in Labour Market Developments supports AUD and Widening Bond Spreads.
The contrast between developments in the US and Australian labour markets over the last week emphasises our point that significant question marks remain on the sustainability of any recovery in the US. This contrast also provides some support to our views that the AUD can move to US96¢ over coming months while the margin between 10 year AUD government bonds and US government bonds can move out from the current 215 basis points to 250 basis points.
This week Australia reported unexpected positive employment for October – with a rise of 24,500 compared to market consensus estimates of -10k and Westpac forecast of -20k. The negative forecasts were based around a likely statistical reversal following a 'surprise' increase of 41,000 jobs in September. The fact that another positive was registered is hugely significant. The long running decline in trend annual jobs growth reversed for the first time in this cycle from an upwardly revised -0.03 per cent to 0.01 per cent. This puts real doubt around our current forecast that trend jobs growth will bottom out at -0.3 per cent and therefore our forecast that the unemployment rate (which increased from 5.7 per cent to 5.8 per cent) will peak at 6.5 per cent next year. A much lower peak must now be envisaged with the outlook for employment growth improving markedly over the last 2 months.
In contrast, the US jobs report showed a rise in the unemployment rate to 10.2 per cent in October from 9.8 per cent in September. This rise in the unemployment rate is despite the labour force participation rate dropping to 65.1 per cent – the lowest since the early 1980's recession.
The chart contrasts the remarkable flexibility of the Australian labour market in this down turn with previous periods.
More flexibility in the response of employers to the slowdown in sales growth has buffered the rise in the unemployment rate and crucially supported Consumer Confidence. This contrasts with the allegedly more flexible US labour market where jobs and Confidence have been decimated.
Furthermore, US annual hourly earnings growth continues to slow from 2.7 per cent in July to 2.4 per cent in October. Other measures of US wages growth are even more disturbing. The broad measure of wage and benefit costs rose by only 0.75 per cent on an annualised basis for the six months to June and the measure of nominal hourly compensation for the business sector fell by 2.25 per cent over the first half of 2009 (as noted by Vice Chairman Kohn in a recent speech). These deflationary pressures which are emanating from a deteriorating labour market are likely, if sustained, to make US long bonds at 3.5 per cent reasonably attractive buying despite the huge surge in supply.
Certainly the feedback loop from incomes to spending and Confidence challenges the 'standard' view that the labour market is lagging indicator of activity.
In contrast, despite our rather benign forecast that the quarterly Wage Price Index which prints next week will slow annual growth, we expect it to be a still 'respectable' 3.5 per cent. Recovery in labour market conditions can now expect to see wage pressures rebuilding in the Australian economy. While we expect AUD bond rates to be on the rise US bond rates can fall as these deflationary risks overwhelm supply as the key driver of their bond rates.
Bill Evans is chief economist at Westpac.