WEEKEND ECONOMIST: Inevitable injection

The Reserve Bank says easier conditions are having an effect but with national accounts showing growth momentum slowing and ongoing weakness in the labour market, there is room for stimulus.

In February we extended the target date for the last Reserve Bank rate cut in this cycle from March to June. That proved to be a prudent decision given that the Reserve Bank board opted to hold rates steady at its March meeting.

The reasons for the extension are clearly set out in the Governor’s Statement accompanying the March decision. This was largely unchanged from the statement issued following the February meeting, which was also a "no change” decision. Of most importance was retaining the view that: "the inflation outlook, as assessed at present, would afford scope to ease policy further should that be necessary to support demand”. That indicates the board still carries an easing bias and future decisions will be shaped by the growth profile rather than inflation risks.

By far the most important data release since the February meeting was the Private Capital Expenditure (Capex) survey for the December quarter. This provided the first estimate of investment plans for the 2013-14 financial year. It also provided the fifth updated estimate for investment in 2012-13. The news on 2012-13 was quite poor with substantial downward revisions. However, partly because the 2012-13 number was lower, it was not too big a stretch for the 2013-14 plans to show a solid increase. Indeed by our calculations those plans indicated an 11 per cent boost in investment in 2013-14. That evidence is likely to have been a key factor in the bank’s decision to hold rates steady. Certainly, when we saw that result we revised back our forecast for the next cut from March to June.

Another aspect of the capex survey indicated that the peak in resource investment might be further out than previously assessed. However this depends on how much slippage is assumed to occur between plans and final spend. Using the most recent history, the capex plans could be assessed as indicating a 9.5 per cent rise in mining investment in 2012-13 and a further 11 per cent rise in 2013-14, i.e. a peak that would not be reached until 2014-15. However using a longer history, which we favour, the capex plans imply growth of 19 per cent in 2012-13 and only 2 per cent in 2013-14. Considering that investment growth in 2011-12 was 72 per cent, the latter profile seems more realistic.

The bank’s description of the international situation was largely unchanged between February and March although the governor appears to be a little more confident around downside risks. Compare the comment: "downside risks appear to have abated, for the moment at least” in February with: "downside risks appear to have lessened in recent months” in March. We remain highly sceptical around Europe's prospects and expect economic activity to contract in both 2013 and 2014. Following the recession that has already been registered in 2012 three consecutive years of recession are likely to engender social, political and financial sector instability. We agree with the Governor who continues to point out that financial markets remain vulnerable, adding "as seen most recently in Europe”.

The governor’s key theme is reiterated in the statement: "the full impact of this [easing in monetary policy] will still take more time to become apparent, there are signs that the easier conditions are having some of the expected effects”. Our view is that those signs remain muted and highly vulnerable to ongoing weakness in the labour market.

We believe that there will be another cut in this cycle but not until around June. Developments that are most likely to highlight the need for lower rates will be around: an ongoing softening in the labour market; contained price and wage pressures; a disappointing response from business in terms of investment; and a housing recovery that, while quite vibrant in Sydney, will not be replicated around the country.

In that regard the fourth quarter national accounts, released the day after the March Reserve Bank board meeting, highlights the need for more stimulus. GDP growth printed at 0.6 per cent for the quarter, in line with downbeat expectations (the median market forecast was 0.6 per cent). Annual growth held at 3.1 per cent, a little above expectations as the third quarter growth was revised higher to 0.7 per cent from 0.5 per cent.

While annual growth was 'near trend' the economy showed a clear loss of momentum over the course of 2012. Quarterly GDP growth was: 1.2 per cent for the first quarter, 0.6 per cent for the second, 0.7 per cent for the first and 0.6 per cent for the fourth. That means that for the last three quarters the economy has been growing at an annualised pace of 2.5 per cent. Westpac expects that growth will hold around 2.5 per cent in both 2013 and 2014 – markedly below long run growth of around 3.25 per cent.

Non-mining businesses appear reluctant to invest and employ. Machinery and equipment investment contracted 3.3 per cent in the fourth quarter to be down 0.7 per cent for the year. Hours worked contracted 0.1 per cent to be down 0.3 per cent for the year. Households came under significant pressure. Real incomes were flat in the quarter. Consumption rose by only 0.2 per cent in the third quarter and by 0.2 per cent in the fourth. The modest fourth quarter increase was funded by a small fall in the savings rate but the more striking aspect is that households have opted to hold their savings rate at a very high level despite the slowdown in incomes: the rate remains above 10 per cent.

There were some signs of rebalancing in investment drivers. In particular, new housing investment registered a solid 3.4 per cent increase in fourth quarter with a clear response to lower interest rates. Housing investment growth has lifted to a 12 per cent annualised pace in the last two quarters following contractions in the five previous quarters.

That has been offset by an 8 per cent contraction in alterations and additions though as household restrict discretionary spending. Exports have also improved, growing by 3.3 per cent in the quarter to be up by 6.2 per cent over the year. That is despite international conditions becoming less favourable. Australia's terms of trade declined by 2.6 per cent for the quarter, 12.9 per cent for year in the fourth, to be 16.5 per cent below the peak of 2011's third quarter.

The Reserve Bank will be discouraged by the dynamics disclosed in the accounts. Weak business confidence is weighing on jobs and investment. Meanwhile, households remain focused on maintaining a high savings ratio with weak household income growth translating into weak spending. While the recoveries in housing and exports are welcome, a cautious consumer weighed down by weak income growth will constrain Australia's ability to maintain solid economic growth in face of a substantial mining slowdown.

We expect that the bank will eventually act on the need to further boost jobs and confidence with a further rate cut by June.

Bill Evans is Westpac's chief economist.

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