WEEKEND ECONOMIST: Headwinds ahead
While rates are expected to rise by 50 basis points between May and August, a number of economic headwinds – including the unwinding of the stimulus and weak credit growth – are likely to lead to an extended pause in the second half of the year.
We continue to expect a 25-basis point hike in May to be followed by a further hike of 25-basis points in July/August prior to an extended pause through to the second quarter of 2011.
Markets had expected only one hike by July but are now in line with our thinking that rates will be increased by a total of 50-basis points by July/August. However, market pricing differs significantly from our expectation of an extended pause. Markets expect the cash rate to reach 5 per cent by December and 5.25 per cent by March 2011.
Our thinking is partly driven by our estimate that the RBA sees 'neutral' or 'normal' as 4.5 per cent – only 50-basis points from the current level. Our estimate has been based on comments from RBA officials that the margin between private sector rates and the official cash rate has increased by 100-basis points since the GFC began. The average cash rate over the period January 1992 (when inflation had settled around its current levels) and December 2007 was 5.5 per cent and underlying inflation averaged 2.6 per cent. It's reasonable to assess that the Bank would consider the 'old normal' as 5.5 per cent – hence our assessment of the 'new normal' as 4.5 per cent. This assessment was given support from comments by Assistant Governor Lowe, who noted last week that mortgage rates are currently 50-basis points below the "average of the last one-and-a-half decades".
Our difference with market pricing may represent the market's view that the 'new normal' is higher than 4.5 per cent or more likely that it expects that growth momentum in the second half of 2010 and early 2011 will be sufficient to require an immediate move into 'contractionary territory' for monetary policy.
We accept that the stimulus to incomes in the economy from the return to 2008 highs in the terms of trade over the course of 2011 will require policy to eventually move into the contractionary zone.
However, we expect that the economy will face a number of headwinds over the second half of 2010.
Unwinding of the fiscal stimulus
We will see the winding down of most of the stimulus initiatives from the Federal Government. These contributed around 60 per cent (2 percentage points) of the growth in expenditures in 2009. Over the course of 2010, as programs are unwound or phased out, we can expect the stimulus effect to detract around 1 percentage point from growth in demand. While the economy probably felt stronger in 2009 than it actually was, it will feel weaker than it actually is through the course of 2010.
Sensitivity of consumer sentiment
The next stage of rate hikes is expected to significantly reduce consumer sentiment and moderate the pace of domestic spending. A movement to 4.5 per cent is likely to see the variable mortgage rate reach nearly 7.5 per cent. At the equivalent stage of the last tightening cycle in March 2005 the increase in the variable mortgage rate to 7.5 per cent resulted in a violent 15.5 per cent fall in consumer sentiment. While there were other factors at work the severe jolt to confidence contributed to rates remaining on hold until May 2006.
Furthermore, the current very strong read on consumer sentiment is not seeing the style of surge in consumer spending normally associated with these lofty levels of the Index. We note in our survey work that consumers are currently much more risk averse than at similar stages of past recovery cycles. In the March Consumer Sentiment Report we noted that the proportion of respondents who indicated that "pay down debt" was the wisest place for savings reached record levels. Those factors point to a more modest upswing in consumer spending in 2010 and 2011 than would have been the case in previous cycles.
A modest fall in the unemployment rate
While our forecasts are for jobs growth of 3 per cent through 2010 we are only looking for a reduction in the unemployment rate to 5.0 per cent by year's end. That will be largely because of an expected increase in the participation rate and the ongoing rise in the labour force associated with the almost doubling of population growth over the last 5 years. We have argued that a central bank will be very nervous if rates are below "neutral" and the unemployment rate is below the NAIRU (non accelerating inflation rate of unemployment). We assess that the NAIRU for Australia is 5 per cent – only 0.3 percentage points below the current level.
If we are wrong with this assessment and the unemployment rate has fallen below, say, 4.5 per cent through 2010, then it is likely that current market pricing WILL be franked.
The provision of credit will also be more constrained in this upswing than in previous cycles. Prior to the GFC, banks were able to access adequate wholesale funding at very narrow spreads. That allowed them to easily accommodate any unexpected increase in the demand for credit from households or business. Now banks are more restricted by market conditions. Funding costs in term wholesale markets have contracted by around 70-basis points over the last year but are still around 100-basis points over bond for three year issuance rising to more than 200-basis points for 10 year funds.
Australian banks would also be anxious about the sheer volume of long-term wholesale debt. In 2009, banks issued $177 billion in term wholesale debt compared to $92 billion in 2008 and $58 billion in 2007.
In addition, new regulations are likely to restrict the extent to which they can access wholesale funds whilst requiring significantly more holdings of sovereign debt. Total credit growth is currently running at an anaemic 1.5 per cent per annum. We expect that credit growth in this cycle will peak at around 9 per cent by end 2011 – well down on the average annual pace in the last 10 years of around 12 per cent. In effect the banks will be performing some of the function of financial tightening which has been the sole responsibility of the Reserve Bank and interest rate policy.
Prospects for growth in the Developed World look grim
Finally, we are less than optimistic about growth prospects in the developed economies. Headwinds associated with excessive levels of official debt; unwinding of stimulus policies; shortages of bank capital; regulatory uncertainty; structural changes in the labour market; and deleveraging of the household sector point to growth disappointments in the US, Europe and Japan over the course of 2010 and into 2011.