Weekend Economist: Rates rationale

The Australian dollar has shown unusual resilience. With rate cuts now less likely, the currency could remain higher than some anticipated.

On March 17 Westpac revised its forecast for the Reserve Bank of Australia cash rate, eschewing any more rate cuts in the cycle and predicting that the next move will be up by the second half of 2015. I am marketing in Asia for the next 2 weeks and below I set out the executive summary of my marketing document. That summary captures our core views around Australia and the world economy and puts the revised rate view into context.

The world economy slowed in 2013 from growth of 3.2 per cent in 2012 (5.2 per cent in 2010; 4 per cent in 2011) to 2.9 per cent in 2013. We expect a modest lift in growth in 2014 to 3.2 per cent although the International Monetary Fund is more upbeat, expecting 3.7 per cent. The US economy is likely to remain "stuck" around a below trend rate of 2.2 per cent despite a reduced drag from fiscal policy. We expect a renewed slowing in housing and business investment as businesses remain cautious and continue to focus on cost cutting and productivity gains. Europe is likely to barely emerge out of a two year recession. China will be comfortable with growth in the 7–7.5 per cent range as it works through excessive credit growth and makes some gestures towards restructuring the economy to encourage consumer spending. Volatility in emerging markets is likely to be an ongoing theme in 2014 as they struggle with the trade-off of offering sufficiently high real interest rates to attract adequate capital while being mindful of the impact higher rates have on fragile domestic economies.

In such an environment it is little wonder that we are predicting modest growth for Australia in both 2014 (2.7 per cent) and 2015 (3.2 per cent). That growth forecast for 2015 is predicated on interest rates remaining steady until the second half of 2015 when we expect the Reserve Bank will begin the process of returning the record low cash rate to more normal levels. We expect the cash rate to rise by 50 basis points in the second half of 2015. Unusually for this stage of the cycle there are a number of significant headwinds facing the Australian economy. Firstly, we have seen a peaking of mining investment expenditure. The boom has been dominated by six large LNG projects all of which have run significantly over budget prompting investors to eschew any major new projects. Fortunately, growth (as opposed to employment) will be cushioned by a substantial lift in net exports. Whereas in 2015/16, compared with 2011/12, the mining investment cycle will subtract around 1.5 percentage points from growth the boost to export growth will add around 1 percentage point to GDP growth. Nevertheless, particularly from the perspective of the labour market, it will be important for growth to rebalance towards non mining investment; consumer spending and residential construction.

In this regard the picture is mixed. Businesses have shown considerable resistance to expansion, either through investment or employment. The last six months of 2013 were the weakest from the perspective of jobs growth since the early 1990s, although we have seen a solid lift in jobs growth in the first few months of 2014. The dominant business strategy has been to protect profits by increasing work hours and constraining wages. Wages growth is the slowest in 20 years. Demand for labour has, to date, not responded to record low interest rates apart from in the residential housing market where progress has been heavily regionalised. Recently we have seen a marked lift in assessed business conditions and employment intentions. If these tentative results are accurately signalling a solid lift in employment and investment then prospects for above trend growth in Australia will improve. The combination of this lift; some upward revisions to the consumer spending profile and the lift in employment in the first few months of 2014 have prompted us to revise our interest rate forecast from a further two rate cuts in the second half of 2014 to steady rates over that period.

The lift in business confidence is likely reflecting more buoyant economic conditions in 2013 December quarter when consumer confidence peaked at 110. Since then, consumer sentiment has lost 10 per cent with households becoming concerned about prospects for rising interest rates and further tightening in fiscal policy at a time when labour market conditions had weakened sharply. Anxiety around job prospects and security has intensified in recent months.

A further threat to consumer spending will be the likely rise in the unemployment rate through 2014. Despite lacklustre jobs growth and strong population growth, the unemployment rate has only increased by around 0.4 per cent over the last year as the participation rate has declined markedly. While the falls in participation were largely due to population ageing in the period to 2012 only 20 per cent of the fall in 2013 was ageing related. The cyclical "discouraged worker" effect was largely dominant in the past year. With participation around a cyclical low the unemployment rate looks set to climb. We expect the unemployment rate to print 6.5 per cent by end year, potentially unnerving consumers. In the latest updates on the labour market, we have seen an improvement in jobs momentum over the past two months. It seems that the "hiring freeze" which dominated employment decisions in the second half of 2013 around Federal election time has thawed somewhat. That may mean that those folks who currently hold jobs might start to feel a little more secure given that the weakness in jobs was centred around minimal hiring rather than a lift in dismissals.

Interest rates are at 50 year lows but do not appear to be boosting business investment and spending in the broader economy. The Reserve Bank has become nervous around the prospect of further cutting rates for fear of sparking an excessive lift to house prices. We anticipate that house price gains and new lending growth will slow through 2014. Melbourne and Perth housing markets are likely to cool, given high starting points, while markets in SA and Tasmania will be contained by some ongoing structural challenges faced by those economies. It is only in Sydney where income growth has outstripped prices that further "catch-up" is likely. The Reserve Bank has shown a high degree of sensitivity to the recent boost in inflation in the December quarter – eschewing its policy to "talk down" the dollar with a subsequent lift in the Australian dollar to $US0.90 from $US0.865. We expect these inflation concerns are overstated. The dominant influence on inflation is likely to be the soft wage environment, although the Bank is expecting that the pass through to inflation from the weaker Australian dollar in 2013 will extend into the March quarter resulting in a 0.8 per cent read on core inflation. That outcome would severely unnerve markets.

With rates on hold through 2014 any further fall in the Australian dollar can be expected to result from ongoing weakness in the terms of trade. We expect the terms of trade to fall by 6 per cent in 2014 with associated falls in the Australian dollar to $US0.88 by year's end. Despite downside risks to Chinese and emerging markets' growth supply constraints are likely to limit the extent of any price falls of iron ore and coal prices. Further out, rising interest rates and sharply improving trade position are likely to boost the Australian dollar back into the high $US0.90s.

Bill Evans is Westpac's chief economist.

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