As expected the Reserve Bank Board decided to leave the cash rate unchanged at 3.5 per cent at its September Board meeting. However, the statement accompanying the decision was by no means formulaic. We were quite unnerved by the marked deterioration in the Governor’s assessment of the world economy and the recent falls in iron ore prices.
He noted that risks to world growth were to the downside. Not surprisingly the rather complacent assessment of China which we saw in the August statement changed markedly. He referred to "some recent indicators have been weaker which has added to uncertainty about near-term growth”. The assessment of Australia’s terms of trade was markedly downbeat. They are described as having "declined significantly since the peak”. This is a material change in tone for a central bank that usually avoids such strong language. A reasonable conclusion is that this has come as a major shock and developments on the China data and commodity prices over the next few weeks will be important to the next policy decision.
We were expecting that the June quarter GDP print would show strong momentum – dampening but by no means extinguishing our expectations for rate cuts. In the event, the growth rate was a soft 0.6 per cent for the quarter – a very disappointing result. Following the 1.4 per cent jump in real retail sales for the June quarter (around 40 per cent of consumer spending) that was available in advance of GDP, we expected that consumer spending would grow by around 1 per cent. In the event it grew by a disappointing 0.6 per cent with both retail and services components growing by around 0.3 per cent. Motor vehicles were the exception with volumes booming by 9.9 per cent. This rise is much stronger than had been indicated by the number of new vehicle sales which, for consumer led segments, were up just 1.8 per cent.
In effect a higher than previously expected proportion of the $1.9 billion in fiscal payments to households was saved. Consistent with that hypothesis is a reported increase in the savings rate from 8.9 per cent to 9.2 per cent. The accounts indicate clearly that the household sector’s caution is firmly entrenched.
Other significant takes from the report were the third consecutive quarterly contraction in machinery and equipment investment. That infers strongly that confidence outside the mining sector remains fragile in the wake of soft demand and global uncertainty. Spending on residential housing contracted for the fifth consecutive quarter to be down by 6.7 per cent over the year.
The terms of trade fell by 0.6 per cent in the quarter, to be down by 7.1 per cent for the full year but 9.2 per cent over the last three quarters. That compares with 18 per cent over the four quarters to September 2009, during the spectacular adjustment in the wake of the Global Financial Crisis. Over that period Australia’s trade weighted index fell by 23 per cent while it has gone broadly sideways over the last nine months. Of course, since June the terms of trade have fallen further in the wake of the 7.5 per cent collapse in Australia’s commodity price index to end August. The RBA worries a lot when global shocks such as the sharp fall in the terms of trade are not buffered by a compensating fall in the currency. A sluggish exchange rate adjustment puts direct pressure on interest rates to bring about the right balance of financial conditions.
On the domestic front, the August employment report failed to show an increase in the unemployment rate – the result that would have been consistent with the economic environment being depicted by other indicators. Total employment fell 8800 but the unemployment rate fell from 5.2 per cent to 5.1 per cent. That was because the participation rate fell to its lowest level since January 2007 with 35,000 workers estimated to have left the workforce. Indeed, had the participation rate not declined over the past year, the unemployment rate would now be around 6 per cent. Employment has now grown just 0.5 per cent over the past year while hours worked are down by 0.7 per cent.
One measure of aggregate labour market slack that is not affected by the structural fall in the participation rate is the employment– to–population ratio. This ratio deteriorated in August to 61.68 per cent, its lowest level since November 2009. Since its November 2010 peak, the working age population has risen by 405k, but only 86k jobs have been created, leaving the ratio 0.9ppts lower. Clearly a structural change is occurring in the labour market, one that is not supportive of overall household incomes.
The issue is whether despite a fall in the unemployment rate the August Employment Report could be described as weak. Weak jobs growth is almost certainly the by product of the sharp fall in the participation rate. After all if the labour force falls by 20k it is reasonable to expect jobs would be lost. However that does not explain why the participation rate is falling in the first place. It seems bizarre that a discouraged worker effect would operate when the unemployment rate is so low. But if there is a serious mismatch between job skills and job openings such a development could occur reflecting a dysfunctional labour market. It may certainly also be a partial explanation for the high degree of insecurity which households feel around their jobs as depicted by the Westpac Melbourne Institute index of unemployment expectations. We will get a new read on that Index next week but, to date, confidence levels are the lowest since the early 1990s (excluding the GFC).
Further complicating the picture has been a positive market response to the ECB's latest announcement around the introduction of the Outright Monetary Transactions policy tool. The impact of those decisions on Reserve Bank thinking are likely to be constructive. Note the Governor's comments last Tuesday. "Financial markets have responded positively over the past couple of months to signs of progress in addressing Europe's financial problems, but expectations for further progress are high."
A reasonable interpretation of that final comment is that the Bank was somewhat sceptical that the ECB would deliver enough to satisfy markets. The market response was positive although it remains vulnerable to the details and whether the conditions of usage of the OTM facilities will be too onerous for potential users. Further, the ECB's decision provided a boost to the AUD pushing it further away from fair value.
Overall, a very eventful week has, on balance, not diluted the case for lower rates. We retain our view that there will be two rate cuts in the December quarter followed by a further cut early in 2013.
Bill Evans is Westpac's chief economist.