We have revised down our forecast for low point for the Reserve Bank cash rate in this cycle from 4 per cent to 3.5 per cent. A number of developments over the last week have prompted this revision.
On Tuesday we received the November Statement on Monetary Policy from the Reserve Bank. There were some important observations in the research section which have cast important light on two important issues.
The first assesses the impact of monetary policy on private sector borrowing rates. Any discussions of "neutral" monetary policy should be made on the basis of private sector borrowing rates – not the actual level of the cash rate. The Statement notes that despite 125 basis points in rate cuts by the RBA in September and October and an associated 122 basis point reduction in prime variable mortgage rates, the household borrowing rate had fallen by only 73 basis points and the average rate on all outstanding business loans has fallen by around 70 basis points.
For the household sector (where mortgages represent around 85 per cent of total debt) that was due to a rising proportion of fixed rate mortgages; smaller cuts in "non-prime" mortgages (around 90 basis points); negligible cuts in personal loan rates; and some actual increases in credit card rates.Since July last year (excluding the latest 75 basis point cut) the RBA has cut rates by a net 25 basis points whereas prime variable mortgage rates have actually increased by 50 basis points. Further, we estimate that household rates have actually increased by around 60 basis points and business rates have risen by around 50 basis points.
Whereas in the September-October period banks were able to pass on virtually all the rate cuts to the variable prime mortgage rate, there has already been 'slippage' for the 75 basis points in November with the pass-through ranging from 58 to 65 basis points. The credit crisis has had a direct impact here – banks have been less successful than normal in cutting retail deposit rates to match the RBA's cuts as some of the smaller banks hold up deposit rates despite the recent government guarantees. Perhaps access to global wholesale markets through the government guarantee for the smaller banks will take some pressure off retail deposit rates.
The net result of these developments is that monetary policy is less effective than in past cycles. Because policy is aimed at private borrowing rates which directly affect confidence, incomes and spending, the "neutral" RBA cash rate is now lower. We estimated "neutral" at around 5.5 per cent – that is now probably more like 4.5 per cent.
A decision to move rates back to "neutral" by year's end (a 75 basis point cut on December 2) seems eminently sensible and the market's estimate of 100 basis points cannot be dismissed as fanciful. Of crucial importance will be the response of the banks. If retail deposit rates remain insensitive to the RBA cash rate then the banks will probably lag the rate cut even more than we saw in November – that would be a strong signal for us to further lower our end point target.
Our final target of 3.5 per cent has already been 'run over' by market pricing, which is already at 3 per cent. However the market's assessment that rates will be quickly rising by 100-120 basis points in the second half of 2009 seems curious. We expect that the Bank would be very unlikely to manage events such that a turnaround in the policy stance would be so rapid – better to be a little conservative on the way down and hold rates in the expansionary zone for a respectable period rather than be required to reverse policy almost immediately. Westpac does not expect the growth environment to recover so quickly in the second half of 2009 to require an immediate tightening.(The 2001 rate cut cycle bottomed out in December and was reversed in May 2002 and the 1996-97 cycle bottomed out in September and was not reversed until November 1999).
A second important issue that received some attention in the Statement was the issue of the wealth effect on consumption. Given the collapse in household wealth in 2008, spending is likely to be curtailed in response to a loss in wealth. The Bank estimates in the Statement that since the beginning of the year household wealth has fallen by 8 per cent. With housing representing about 58 per cent of household wealth, superannuation 22 per cent, direct shares 7 per cent and bank deposits and other 13 per cent, these estimates are complex.
The other complexity is the link between wealth loss and spending. Recent research indicates long-term spending would fall by 3 per cent of any wealth loss in housing, 9 per cent for shares and we have not seen any estimates for superannuation. The Bank uses an estimate of 4 per cent for total wealth in the Statement. Such estimates are subject to huge variation. For example, it could be argued that if the fall is concentrated in equities and superannuation where the 'high spenders' are more affected, the sensitivity is higher.
Using the 'conservative' 8 per cent wealth fall and 4 per cent long term (say 2 years) impact on spending, nominal consumer spending would fall by around 1.7 per cent per year over two years. If, however, the fall in wealth bottoms out at 12 per cent and the sensitivity is 6 per cent rather than 4 per cent, then nominal consumer spending would fall by nearly 4 per cent. Such a wealth effect would put enormous pressure on demand in the economy.
Blunted monetary policy and a substantial wealth effect put considerable pressure on both fiscal and monetary policy to support disposable income to avert a collapse in consumer spending. For instance we estimate that the $10.7 billion fiscal stimulus package, the known tax cuts and our profile for RBA cash rates will boost household disposable income by 3.6 percentage points in 2008/09. That will be needed to offset the reduction in income growth stemming from the slowdown in jobs growth (to below 1 per cent in 2009) and the reduction in spending stemming from the negative wealth effect.
Overall nominal consumer spending growth can hold at around 3-4 per cent (around 1 per cent real) – a positive result but with little flexibility. A more conservative monetary policy would jeopardise this wafer-thin result or a more blunted pass through from the RBA cash rate to private rates would have a similar impact. There is no room for conservative monetary policy even though fiscal policy has been supportive.
Of course, these results will be even further threatened if the labour market deteriorates even more quickly than we expect. A chilling reminder of this risk came with our measure of unemployment expectations from the November 12 Consumer Sentiment release. Despite the moderate rise in Consumer Sentiment there was a further significant deterioration in consumers' highly pessimistic unemployment expectations. The level of the Index is consistent with a severe slowing in full time jobs growth – a contraction in the first half of 2009 – at this stage a similar result to 2001 when total jobs growth bottomed at around 0.5 per cent (Westpac's current forecast).
Nevertheless, all risks now point to the downside on jobs, further emphasising the need for aggressive fiscal and monetary policy.
Bill Evans is the chief economist at Westpac.