WEEKEND ECONOMIST: Nearing the nadir
Unemployment and trade concerns gives the RBA adequate motivation to slice again in November. External uncertainly will see the bank retain a 'flexible' stance for a while before flattening out.
Our scrutiny of the governor’s statement indicates that the case is still strong for a further rate cut in November of 25 basis points.
Firstly the bank is much more downbeat on the labour market. For the first time it has pointed out that despite the low unemployment rate the labour market has "generally softened somewhat in recent months”. This observation is consistent with our view that a number of other labour market variables around participation; confidence; employment intentions; and employment growth are all pointing to a weak labour market. We maintain our call that the unemployment rate will reach 5.7 per cent over the next six months reflecting these lead indicators and a likely stabilisation of the participation rate.
Next week we will receive the September employment report.
Recall that the participation rate, having averaged around 65.3 per cent in the previous four months fell sharply to 65.02 per cent in August. That fall is partly explained by the 'discouraged worker' effect as people, particularly full time males, leave the workforce, but may also represent a statistical overshoot. If, for example, the participation rate corrected back to 65.2 per cent in September the workforce would increase by 46,000. A modest jobs increase of around 15,000 would see the unemployment rate jump to 5.4 per cent. Our central view is for a more modest rebound in the participation rate with the unemployment rate rising to 5.2 per cent. Nevertheless the risk is that next week's employment report could reveal a sharp increase in the unemployment rate.
The second important observation is that for the first time the Reserve Bank is recognising the need for other components of demand to regain some strength because the peak in the resources investment cycle will be in 2013. This is a revision to both the timing (previously expected 2013-14) and size of the peak, ”maybe at a lower level than earlier expected”. This recognition changes the required emphasis for policy from containing alleged price pressures emanating from income and activity stimulus from the mining boom to recognising that demand conditions are likely to soften markedly in 2014 unless there is a boost to the traditional interest rate sensitive sectors of the economy including house construction, non residential construction and consumer spending. From our perspective it is encouraging that the bank has recognised that weakness in these sectors will not be compensated by mining investment for much longer.
In September the governor recognised that commodity prices have fallen sharply and the terms of trade have declined. In October the governor goes further to point to a fall of over 10 per cent in the terms of trade to end June and a view they "will probably decline further". In that regard we expect a further fall of 9 per cent in the terms of trade in the second half of 2012 – making the cumulative decline comparable to that seen in 2008-09. The Australian dollar has recently fallen from $US1.045 to $US1.025 and is on track for our end year forecast of $US1.01, but such a fall will be well short of compensating for the fall in the terms of trade, effectively tightening financial conditions.
We have long argued that interest rates are only slightly below the ‘neutral’ level. The Reserve Bank points out that rates to borrowers are indeed "a little below their medium term averages” and yet "credit growth has softened of late”. The 'neutral' level for the cash rate is around 4 per cent. It will be affected by the response of the banks to this rate cut. Only one bank (a non major) has responded so far with a 20 basis point cut in the mortgage rate. If all banks were to follow that lead neutral would fall by a further five basis points.
In September the Reserve Bank referred to "a more subdued international outlook”. In this statement the board goes further to argue that "on the back of international developments the growth outlook for next year looked a little weaker”. These developments mainly relate to "uncertainty about near term prospects” in China and that around Asia generally growth is being dampened by "the more moderate Chinese expansion” and "the weakness in Europe”.
There is no change around the view that Europe is contracting and US growth remains modest.
We broadly agree with those views around Europe and the US with our forecasts for 2013 including a further contraction in Europe and ongoing modest US growth. However, we do expect a sustainable lift in growth to emerge in China through 2013.
The final sentence in the Governor’s Statement is very important: "The board therefore decided that it was appropriate for the stance of monetary policy to be a little more accommodative." This does not commit to a further imminent cut but also does not indicate that there is an intention to hold rates steady in the near future – flexibility has been retained to move again.
As we discussed in the weekly note the inflation report on October 24 will be important for the November decision. Westpac currently expects that underlying inflation will print around 0.8 per cent for the quarter with 0.3 percentage points of that being directly attributed to the carbon tax. The ABS will not estimate the impact of the carbon tax on that print and it will be up to the RBA and Treasury to make their own informal assessment. That event therefore represents more uncertainty than a normal CPI but we are confident that the other arguments being used to justify the October move will adequately compensate for some uncertainty around the inflation report.
Readers will be aware that it has been Westpac’s forecast since last May that the low point in this cycle will be a cash rate of 2.75 per cent and we believe that policy is on track for that result with the next cut in November and the final cut likely to occur in the first quarter of 2013.
Markets, however, have 'run over' our forecast. They are now forecasting a low point in the overnight cash rate of around 2.25 per cent.
Furthermore fixed rates have fallen sharply. Three-year swap rates are down to 2.8 per cent. That compares with around 3.4 per cent when the RBA's cash rate was last at 3.25 per cent. Clearly markets are not only expecting a lower low in the cash rate in 2013 but, more importantly, that it will stay low for a lot longer in 2013 and beyond than was the case in 2009 when the bank began retightening in October of that year.
For those of us who feel the responsibility to give steady medium term guidance to our customers it is dangerous to be unduly influenced by market pricing (which has had multiple iterations since our 'well below consensus' call in May).
For now, we are comfortable with our consistent theme of a 2.75 per cent low point and steady rates through the remainder of 2013.
Bill Evans is the chief economist of Westpac.