The Reserve Bank of Australia’s (RBA) board next meets on April 3. In our minds the case for further cuts following on from the 50 basis points (bps) delivered late last year has already been made. If it were our decision to make, we would certainly move next week. The bank's decision will be finely balanced and as always determined by subjective judgements. For the board to cut rates, it will need to be absolutely comfortable that the threshold for a move which has been clearly communicated in recent statements – that "demand conditions weaken materially" – has been crossed. While we believe that this condition has already been met, we feel that on balance a prudent central bank will decide to wait. Therefore we are maintaining our forecast for the next rate cut to be in May, followed by July.
This is by no means a clear cut issue. It is our view that the bank has shifted much closer to a move over the last few weeks. And we certainly anticipate that the language in the statement following the April meeting will signal that clearly. We note that market pricing has moved towards 100 per cent pricing for May (in line with our position, up from ~80 per cent last week) and an entirely reasonable ~50 per cent for April (37 per cent last week), with an extra 25bps by July. We interpret this as full recognition that two 25bps cuts are required, rather than the 'one more and done' or 'on hold' views that emerged after the surprise February decision.
We invite readers to consider the arguments below.
In Westpac's recently released quarterly report, Coast to Coast, which reports on the economic performance of Australia's individual states, the nature of Australia's multi-speed economy is starkly emphasised. Demand in the three states which have no significant exposure to the mining boom has contracted. South Australia (–0.6 per cent) and Tasmania (–0.7 per cent) contracted in 2011 while Victoria contracted by 0.4 per cent in the second half of 2011. NSW has received a timely boost from its coal sector but it still only managed to grow at a below-trend 2 per cent in 2011. By way of contrast demand surged in Queensland (10.0 per cent) and Western Australia (11.1 per cent). Overall, growth in Australian demand for 2011 was a 'respectable' 4.4 per cent – a figure which belies the extreme disparities between states. Not surprisingly, the job market was particularly weak in the non-mining states. Over the last six months (to February) jobs contracted sharply in Victoria (–1.0 per cent), and declined in New South Wales, SA and Tasmania. Only Western Australia registered an above-trend performance.
A number of negative forces are acting on the Australian economy, including the high Australian dollar, the deleveraging of the cautious consumer and a tightening of fiscal policy. The first two forces are unavoidable headwinds to certain sectors of the Australian economy, being associated with longer term adjustments. While these changes in the economy might be described as structural – the inevitable outcome from a once in a century surge in Australia's terms of trade and the necessary adjustment to Australia's excessive accumulation of household debt – it is appropriate for both fiscal and monetary policy to support demand through this difficult transition period.
In this regard we had been intrigued by recent commentary from a number of Reserve Bank speakers. Our concern has been that the bank might see changes in monetary policy as irrelevant when the economy is going through profound structural change.
Since the last board meeting we have seen two important speeches from deputy governor Philip Lowe and governor Glenn Stevens. On both occasions considerable attention was given to the theme of structural change. On March 19, in a speech in Hong Kong, the governor clarifies the bank's position on whether demand management is appropriate at times of structural change when he notes that "monetary policy cannot raise the economy's trend rate of growth. That lies in the realm of productivity increasing behaviour at the enterprise, governmental and intergovernmental levels". "Nor can monetary policy obviate the pressure for the production side of the economy to change in response to altered relative prices." He is asserting that monetary policy cannot change the course of supply side events. That is a point with which we agree.
Equally we are relieved to see that Mr Stevens accepts that monetary policy does have a role to play on the demand side, "Monetary policy can play a role in supporting demand to the extent that inflation performance provides scope to do so". He gives further support: "Overall recent economic performance in Australia is not too bad... but neither is it so good that it cannot be improved. The full range of policies – macroeconomic and structural – need to play their part in seeking that improvement." There are echoes here of US Fed Chairman Ben Bernanke's offering at the Jackson Hole conference last year, where the theme was long-run growth. He noted that while monetary policy was not a supply side weapon, it could play a role in improving short-term labour market outcomes, thus ameliorating some of the negative long-run effects of unemployment, such as skill erosion.
It is important to note that this urgency was not apparent in the speech we saw from Deputy Governor Lowe, which also focussed on structural change and was delivered 12 days earlier. In that speech we saw a much more relaxed approach from the Bank, "the various cross currents have balanced out reasonably well from a macroeconomic perspective: GDP growth is close to trend, inflation is consistent with the target, interest rates are around average and unemployment is low".
Of course in that intervening 12 day period we saw a number of developments that might explain the progression from the deputy governor's position to that of the governor. Firstly, the GDP report for the December quarter (Q4) of 2011 printed 0.4 per cent for annual growth of 2.3 per cent. This was the fourth consecutive year when GDP had printed well below the accepted trend growth of 3.25 per cent. (The economy expanded by 1.2 per cent through 2008, by 2.7 per cent through 2009 and by 2.2 per cent through 2010). The RBA's forecast for growth in 2011, with full knowledge of the first three quarters, was 2.75 per cent indicating that its forecast for GDP growth in 2011 Q4 was around 1.0 per cent, an "above trend" quarter, compared to the result of a decidedly below trend quarterly and annual result. It is true that the bank's forecast for growth in 2012 is an 'at trend' 3 per cent to 3.5 per cent. But that is only a forecast and is likely to be reassessed given the weak momentum indicated by the December quarter in 2011. So the 'relaxed' Lowe speech was based on the 2.75 per cent expectation for the year that was defeated by the weak Q4 print, while the Stevens speech was informed by the reality of underwhelming growth.
Digging deeper into those numbers, growth in domestic demand at 0.2 per cent in Q4 was its slowest since the June quarter in 2009. Growth in private final demand was –0.1 per cent, the weakest outcome since the March quarter 2010. Admittedly, the domestic demand print followed a particularly strong 2.2 per cent in the September quarter. That dramatic swing was largely due to the 'correction' to the pace of growth in business investment from 14.2 per cent in the September quarter to –1.0 per cent in the December quarter.
But the other key components of private spending are not distorted in this way. Residential dwelling investment contracted by 3.9 per cent, following a contraction of 0.2 per cent in the September quarter to register the weakest quarter since the June quarter of 2009. Household consumption growth printed 0.5 per cent following 1.1 per cent in the September quarter. This represented the softest growth in household consumption since the March quarter 2010.
Secondly, the February employment report registered a loss of 15,400 jobs and a rise in the unemployment rate from 5.10 per cent to 5.24 per cent despite a 'helpful' fall in the participation rate from 65.3 per cent to 65.2 per cent. This read on the unemployment rate puts it on the limit of Dr Lowe's, 5.0 per cent to 5.25 per cent, noting his comment, "an important indicator here is the labour market with unemployment rate having been in the 5.0 to 5.25 per cent range over the past year. If the unemployment rate were to rise persistently, it might suggest that the contractionary effect of the high exchange rate was more than offsetting the expansionary effect of the investment boom and the terms of trade".
Of course it is risky to be too 'relaxed' about the Australian labour market. In 2011 there was zero jobs growth – the weakest year for jobs since 1992. Despite this, the rise in the unemployment rate has been contained to just 0.3 percentage points (ppts) (from 4.9 per cent to 5.2 per cent) due to a marked fall in the participation rate, concentrated on males. Overall, it is our assessment that the labour market picture is more disturbing than indicated by the modest rise in the unemployment rate. For example, if the participation rate had held steady since September the unemployment rate would have increased to 5.8 per cent. While that is an extreme example, it highlights the underlying weakness that we believe to be present. A broad measure of labour market health that is not 'distorted' by participation shifts, the employment to working age population ratio, has fallen by 0.78ppts over the year to February.
There was also a sharp fall of 5 per cent in the consumer sentiment index for March, largely in response to consumers' concerns around the economy, employment and interest rates. The index has now fallen to 96.1 which is below the level in October which preceded the two rate cuts in November and December. An additional measure in the index – unemployment expectations - moved adversely, by 4 per cent, to register the lowest level of confidence around job prospects (apart from the global financial crisis and one observation in 2001) since the recession of the early 1990s. This deterioration is evident across a wide range of occupations and demographic strata.
Regular readers will be aware that we have been less constructive than the RBA on global growth. As an interesting aside, the governor has actually been in Asia recently, principally to conclude a landmark FX agreement with the People’s Bank of China. This trip would have exposed the governor to the current reality on the ground. Note that the bank's commentary on China and Asia went like so in the statement following the March meeting: "Growth in China has moderated as was intended, but on most indicators remains quite robust overall. Conditions around other parts of Asia softened in 2011, partly due to natural disasters, but are not showing signs of further deterioration." The general tone of those comments is clearly removed from the reality as we see it. It is quite possible that the governor's meeting schedule may have qualified his view on the balance of risks around the China story. That would have material implications for the bank's thinking on trading partner growth and the terms of trade. It is no coincidence that there was a steep decline in the iron ore price in the month leading into the first cut last November. While the prices of key commodities have been stable or higher in the year to date, if the bank is relenting on its 'quite robust' assessment of Chinese growth, then the policy calculus will be undeniably altered.
Another matter worth addressing is the tactical approach of the bank with regards to the impending Consumer Price Index (CPI) report, which will not be available for the April meeting but will be available in May. Our view is that the bank has a different attitude to waiting for inflation reads in tightening and easing cycles. It is more inclined to pre-empt while easing and less inclined to while hiking. In the current disinflationary environment, there seems to be little risk moving ahead of the CPI. For what it is worth, we anticipate a benign 0.6 per cent reading on underlying inflation and 0.7 per cent on headline, due April 24. So the timing of the CPI is not necessarily a restraint on the bank if it were convinced that a rate cut was the appropriate policy, hence our assessment that market pricing for April of as high as 50 per cent is not unreasonable.
Clearly these near term prospects are clouded by nuances, data volatility and subjectivity. Consequently, we are much more comfortable with our expectation that, by the end of the September quarter, the overnight cash rate will be lower by 50bps than it is currently. Clearly there are multiple month by month permutations and combinations that fit that structure. Following the example of the bank's decision in February to defy market expectations, we cannot rule out any particular month for the two moves we expect over this period.
Bill Evans is Westpac’s chief economist.