WEEKEND ECONOMIST: Rate expectations

Concerns over the persistently high dollar, combined with cautious consumer sentiment and subdued labour market conditions, make a November rate cut the best bet.

In the minutes for the September Board meeting, it was made quite clear that the October meeting would not be a "live" one.

Consider the following quote from the minutes: "Members agreed that the Bank should again neither close off the possibility of reducing rates further nor signal an imminent intention to reduce them". That suggests that there is little chance of an October move although the board clearly retains an easing bias. Note in particular that the minutes pointed out that the Australian dollar is "still high" and that "some further decline in the exchange rate would be helpful".

At the time of the September meeting, the Australian dollar was around $US0.90. It has subsequently moved to around $US0.94 so this should, based on the quotes from the September minutes, be quite frustrating for the Board. Of course, the big development around the Australian dollar was the decision by the US Federal Reserve to maintain the same level of bond/ mortgage-backed security purchases rather than taper back some of these purchases.

Given the response of the Australian dollar to the "taper talk" from May ($US1.04) to June ($US0.89), it is hardly surprising that the AUD jumped sharply on the news of "no taper". Furthermore we expect that there will be no tapering in 2013. The October 29/30 meeting will be too close to the debt ceiling debate in the US Congress while the Fed is likely to have to further reduce its growth forecasts for 2013 and 2014 in December. These are hardly backdrops for the beginning of a tapering process. Consequently, to the degree that the Reserve Bank Board is committed to a more competitive Australian dollar, it will have to be conditioned to not having Fed policy as a helpful support. It is generally accepted that a central bank should not target its currency with interest rate policy.

However, I am sure that the Reserve Bank would see the fall in the Australian dollar through May to present ($US1.03 in early May) as being partly due to its rate cuts in May and August and the maintenance of a consistent easing bias. We concur that while the concerns for a hard landing in China and "tapering" were the key factors behind the fall in the Australian dollar, the rate cuts and easing bias policy were helpful complements. Domestic conditions also support lower rates.

Consider the Bank's subdued commentary in the September minutes around the domestic economy: "firms' capital expenditure plans for non-mining investment remained subdued for the coming year"; "mining investment was likely to decline noticeably"; "growth of household consumption ... had been below average ... and liaison contacts reported that retail sales growth had been only modest in recent months"; "labour market conditions remain somewhat subdued ... (and there was) a decline in the employment to population ratio"; "there were further signs that wage growth had eased over the year". The Bank's Financial Stability Review was released on September 24.

The tone of the Review was quite balanced. "Of particular importance is that banks maintain prudent risk appetite and lending practices, especially in the low interest rate environment". The Bank notes "the risk profile of new household borrowing remains reasonably sound and indicators of household financial stress are reasonably low" and there is "a continued rate of excess repayments on home loans". Indicators of household stress provided no grounds for concern. The non-performing share of banks' housing loans was steady at 0.7 per cent; data on securitised housing loans suggests arrears rates have fallen since peaking in mid 2011.

Lending standards are assessed as having been broadly maintained since late 2011. The distribution of high LVR share of loan approvals has shifted down since 2009. The share of low-doc loan approvals has remained steady at 1 per cent in 2013. Self-managed superannuation funds come in for scrutiny, representing a new source of housing investor demand. My point would be that these investors should be put into perspective. Residential real estate assets represent around 3.5 per cent of the SMSF's investments — around $20 billion in assets. That represents around 1.5 per cent of total housing credit outstanding and around 5 per cent of investor credit.

With such a low share of the stock, it seems highly unlikely that the SMSF sector could significantly influence prices through its flow. There was only limited commentary on house prices. Prices have increased by 4.5 per cent since the Reserve Bank started cutting rates in November 2011. If we compare that profile with the previous three easing cycles, we can see the moderation in this cycle compared to previous cycles. Some 21 months after the first rate cut in previous cycles, prices were up by 15.5 per cent (2008/9); 37 per cent (2001/2) and 17.4 per cent (1996/97). The question is whether there are aspects to today's economy that can explain the muted response of prices, so far, in this cycle.

Of most importance is the attitude of Australian households to leverage. In the Stability Review, the Reserve Bank points out that 50 per cent of mortgage borrowers have maintained their mortgage repayments despite mortgage rates falling by nearly 2 per cent. They have also built up mortgage buffers through mortgage offsets and redraw facilities of 14 per cent of balances – 21 months of scheduled repayments. Concerns over debt levels and job security are likely explanations for this behaviour. 

The Westpac Melbourne Institute Index of Consumer Sentiment has recovered back to around its early 2007 level. However, how respondents feel about their job security is still 20 per cent lower. It is unusual for that wedge to have opened up since, typically, confidence and job security are closely aligned. In this current cycle, "job security" is aligned with "business conditions" as measured in the NAB Business Confidence survey. This measure is also around 20 per cent below the 2007 levels. Households' confidence to leverage into a strong property boom will be affected by their assessments of job security and perceptions of debt levels. Note that the savings rate actually increased in the June quarter, indicating that the consumer remains cautious.

The Reserve Bank Board will have to balance potential "bubble" risks, for which there is little evidence after 21 months, with the obvious advantage lower rates imply for a lower Australian dollar and a boost to domestic activity. We think they are likely to opt for another cut in November.

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