Weekend Economist: Lower to go

The Reserve Bank Board decided to lower the cash rate by 25 basis points to 2.25 per cent on February 3. This has been Westpac's forecast since December 4, when it became clear that demand conditions in the Australian economy had deteriorated more sharply than we expect the bank had anticipated. The Governor's post meeting statement confirmed that assessment, as he referred to growth as being below trend but more importantly “domestic demand growth overall quite weak”.

In the all-important final paragraph of the statement, where the bias of policy is usually communicated, the commentary was backward looking, concluding that based upon assessments of the economy and in particular the updated forecasts (subsequently released in the Statement on Monetary Policy, of which a great deal more will be said below), a cut in the cash rate was appropriate.

The language in the final sentence which might have referred to “a period of stability” or “scope to cut further” studiously avoided a judgement on the appropriateness of the “stance” (i.e. the level of interest rates and the mix of financial conditions) or the provision of any forward guidance, simply making the obvious point that “this action adds some further support to demand”. This approach gives the bank full flexibility to determine its next policy move without making any commitment to the market.

Moving forward to the SOMP, the bank has lowered its forecasts for growth and inflation in 2015 despite the fact that the figures were compiled in such a fashion as to include both the February cut and “the assumption that the cash rate moves broadly in line with market pricing at the time of writing”.

Market pricing currently envisages a further full 25 basis points cut plus another possible 10 basis points. In short, the bank is expecting that growth in 2015 will still be below trend despite the current rate cut and the market's expected further rate cuts.

Regarding the medium-term projections (noting that the lag between activity and interest rates can be as long as 18 months), growth in the year to June 2016 is still expected at 3.25 per cent (midpoint) which is the generally accepted trend growth pace for the Australian economy.

Even accepting that the forecast growth reduction is due to an extended weak spot at the end of 2014 and in the first half of 2015 (when monetary policy enacted this year can hardly be expected to have much impact), the fact that the bank is assuming that, with the recent cut along with the market's expected cuts, growth in the zone when monetary policy changes can be expected to have an impact will only reach trend points to the need for lower rates.

Presumably if the bank had made its forecasts on the basis of steady rates then it would have been forecasting below trend growth next year as well as this year.

Prospects for inflation have also been revised down. In November, the bank forecast underlying inflation at 2.25-3.25 per cent in 2015; this estimate has been revised down to 2-3 per cent. That is despite the assumption around the Australian dollar being revised down from US86c in November to US78c in February.

The bank is confident that domestic inflationary pressures will remain subdued. The statement notes that “the direct effects of the exchange rate depreciation since early 2013 are expected to add a little under 0.5 percentage points to underlying inflation over each year of the forecast period.” That calculation indicates that domestic inflation is expected to hold around the bottom of the forecast range. These forecasts are a reasonable signal that the bank forecasts that lower interest rates will be required to return growth to trend, while the inflation outlook has improved despite lower rates and a lower currency.

Not surprisingly, the general discussion in the statement is downbeat. Prospects for consumption, non-mining investment and the labour market have been revised down. On the other hand the bank remains constructive on exports and the housing market. Note the following quotations: “consumption will continue to grow at a below average pace”; “the lower oil prices will contribute around 0.75 percentage points to real disposable income … but will be offset by lower labour incomes”; “the expected recovery in non-mining investment has been pushed out to later in 2015”; “a number of indicators suggest that spare capacity in the labour market has increased, consistent with below trend growth”; “the unemployment rate is expected to rise a little further and peak a little later”; “many firms expect to see a period of low and stable wage growth ahead”; ”unit labour costs will remain well contained”; and “weaker near term outlook ... more than offset the upward price pressures from further exchange rate depreciation”.

Back in December we forecast 25 basis point rate cuts in both February and March. We expected that if the economy evolved as anticipated over the subsequent months the bank would see the case for easing policy. A single cut was considered unlikely given that policy had been on hold since August 2013. Two consecutive cuts seemed to be the appropriate approach.

The SOMP forecasts do nothing to dissuade us from that view. Despite considerably more supportive financial conditions (both realised and assumed) growth beyond the near term is not expected to be any stronger than the forecasts when the bank was on hold. That suggests that the bank is likely to cut again at the next opportunity.