WEEKEND ECONOMIST: Rate cuts revised

An uneven housing recovery has not changed growth or inflation forecasts, but expectations have been revised on the timing of the next rate cut.

We have pushed back our timing for the next rate cut by the Reserve Bank to February next year. Our previous forecast was for one cut of 25 basis points in November and a second of 25 basis points in February. Our revised call is for a 25 basis points cut in February to be followed by a further cut of 25bps in May. Essentially our forecasts for the Australian and world economies have not changed.

We still see GDP growth in Australia in 2014 at 2.5 per cent, only slightly above the below trend 2.2 per cent in 2013. That will include growth in domestic demand of only 1.7 per cent (up a little from the 0.9per cent in 2013); mining investment contracting sharply; non-mining investment remaining very sluggish; and consumer spending growth only picking up marginally from 2.5 per cent to 3.0 per cent.

A significant factor in this modest domestic growth profile will be the global environment. Growth forecasts from the 'official family' (IMF; RBA: Treasury) for the world in 2014 are around 4 per cent, whereas our current forecast is 3 per cent. That includes scenarios of a slower than expected performance in China, particularly in the first half of next year, the US economy remaining in the 1.5 per cent – 2.0 per cent growth range for another year; and a stagnation in Europe (–0.1 per cent).

This soggy world environment is likely to be a major constraint on any sustained recovery in business conditions in Australia, which in turn will constrain prospects for employment growth. We continue to expect that the unemployment rate in Australia will peak at around 6.5 per cent by mid-2014.

Wage and inflation pressures will be contained through 2014. To date, the Reserve Bank has a more upbeat outlook for growth in 2014. Current forecasts are around 4 per cent for world growth; 3 per cent for Australian GDP growth.

While there are no official Reserve Bank forecasts for the unemployment rate, the Commonwealth Treasury is forecasting 6.25 per cent, which is expected to hold through 2014/15. We expect that if the Reserve Bank was setting policy off our forecasts for growth and unemployment, then a November move would still be likely.

However, the recent boosts to business and consumer confidence (both noted by the Governor in his Statement) in anticipation of the expected election result raise the possibility of much more buoyant domestic demand in 2014 than our own forecast.

The Governor has also expressed his caution around these results ("too soon to judge how persistent this will be"), but these comments alone indicate a preparedness to await more information around the resilience of the confidence boost.

We have already pointed out to our customers the evidence in 1996 when a Coalition victory (after a long period in opposition) was greeted with solid boosts to business confidence and consumer sentiment and consumer job security, although business conditions did not react.

Subsequently, consumer confidence and job security faded while business conditions never really responded to the boost in confidence. By February, the Bank will have clear evidence around this sustainability whereas evidence over the next month is likely to be inconclusive.

We have not changed our growth or inflation forecasts in the wake of signs of a sharp recent jump in house prices in Sydney and Melbourne. Our judgement remains that the housing recovery will continue to be a 'stop-start' and uneven one across both segments and states. There are significant headwinds that are yet to fully impact with some markets facing marked increases in the supply of new dwellings (Victoria, Western Australia) and the mining downturn yet to play through fully to housing (Western Australia, Queensland).

More generally, we expect Australian households to continue to exercise balance sheet restraint with a reluctance to increase debt likely to limit the extent to which strong price growth can be sustained. The housing recovery is a key upside risk to the outlook. The Reserve Bank has been appropriately calm in the face of these recent developments and is certainly not buying into premature talk of 'bubbles'. (Aaside from the lopsided nature of the pick up, prices nationally have only just regained their previous peak.)

However, the Board would most likely feel it is prudent to await further information on house prices before it cuts rates again. By February, that evidence will be clearer although housing data over the December/January period is thin. Fiscal policy is a headwind as governments remain focused on budget repair.

Public demand, 22 per cent of the economy, declined over the past year, contracting by some 2.0 per cent in the four quarters to June 2013. In the Federal Government’s August Economic Statement, public demand is forecast to rise by a tepid 0.75 per cent in 2013/14 and improve only fractionally to a still weak 1.0 per cent increase in 2014/15.

Household demand growth over the past year was materially below trend as many households remained focused on paying down debt at the same time as a deteriorating labour market led to slowing growth in wage incomes.

 We expect household demand to gain some momentum from mid-2013, reflecting a more confident consumer as house prices advance. However, any improvement in household spending is expected to be relatively modest, constrained by ongoing soft labour market conditions and preferences to continue deleveraging. In addition, the upturn in dwelling investment remains relatively lacklustre by historical standards, a view supported by the latest approvals data.

Finally, we come to the Australian dollar. Our forecast for the AUD to pull back to $US0.92 by year's end has been predicated on a November rate cut. Under this revised forecast, the AUD is likely to trade up to $US0.95 by year's end and stay in that range until the Reserve Bank acts in February.

Readers will not be surprised that with the growth profile we expect for the US economy, we do not anticipate the Federal Reserve 'tapering' its bond purchase program until well into 2014. Doubts about the markets' super confident views on tapering have been a consistent aspect of our advice to customers since the issue first gained prominence in May this year. The market is likely to continue to harbour expectations for an earlier taper with 'no taper' surprises in October, December and January all providing upside for the Australian dollar.

By February, with the AUD heading in the 'wrong' direction; a clear need to lower both domestic and global growth forecasts; confidence waning; and the surge in house prices looking contained, the Reserve Bank is likely to return to easing policy with two more cuts expected in February and May. We do not expect rates to be rising until well into 2015 when a solid recovery in the world economy starts to become apparent.

Bill Evans is Westpac's chief economist.

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