Weekend Economist: Saving private wealth

The biggest concern for the Reserve Bank ahead of this week's rates decision will be the cautious consumer, but it may only be a matter of time before the 'wealth effect' kicks in.

The Reserve Bank Board meets next week on July 1. We expect it 
to leave the official cash rate unchanged at 2.50 per cent. We expect the governor's statement accompanying the decision to retain the key line that "the current accommodative stance of policy [is] likely to be appropriate for some time yet".

There are likely to be some changes in the rest of the statement however and a possible subtle change in tone. Although the governor's statement accompanying the June Reserve Bank decision had only minor tweaks compared to May, the minutes from the June meeting showed a more uncertain policy deliberation. Whereas in May the board assessed that the "economy had evolved broadly in line with earlier expectations", the June minutes showed that while low interest rates were still seen as supporting demand "it was difficult to judge the extent to which this would offset the expected substantial decline in mining investment and the effect of planned fiscal consolidation".

That more 'open' view combined with the more pointed commentary on the Australian dollar ("the exchange rate remains high by historical standards, particularly given the further decline in commodity prices"), suggests the policy discussion in June was a little uneasier than in May.

That said, the unease was clearly not sufficient for the Reserve Bank to change rates or even make substantive changes to the governor's statement. Even on the currency, the rhetoric stopped short of being 'strident' with no return to the "uncomfortably high" wording deployed in Nov- Dec last year.

The unease apparent in the June meeting minutes is likely to have grown over the last month.

The disconnect between the currency and commodity prices has widened with the Australian dollar up nearly a cent since the Reserve Bank’s June meeting to around 94 US cents currently, despite Australia's commodity prices only stabilising after the sharp falls in Apr-Jun (our WCFI measure including bulk commodity prices such as iron ore is still down 7.6 per cent from the levels prevailing at the Reserve's April meeting).

Meanwhile, the global backdrop is also looking a touch shakier. China's growth slowdown remains delicately balanced with PMIs suggesting the slowing in production is moderating, but a sharp fall in the June Westpac-MNI China Consumer Sentiment survey showing local demand may still be patchy with mixed signals around the housing market. In the US, a hefty downgrade to first-quarter GDP estimates now shows the economy contracting sharply at a pace of 2.9 per cent in the first quarter, prompting downgrades to 2014 growth forecasts although most, including those on the FOMC, appear unperturbed by the fall. And although its unlikely to come as a surprise to the Reserve Bank, the ECB's new aggressive stimulus measures unveiled in June are less likely to be a source of confidence for the Bank as they are, arguably, another source of unwanted support for the Australian dollar.

Domestically, the main source of concern is likely to be the consumer. Indeed, the Reserve Bank’s commentary around the consumer 
is almost certain to change. Last month, it was the 'elephant in the room' in the governor's statement. Very little was made of the softening in retail sales, and there was no mention whatsoever of the sharp pull-back in consumer sentiment following the May federal budget.

The minutes to the June meeting provided more elaboration. The Reserve Bank board viewed retail as coming from a strong starting point and the sharp post-budget fall in sentiment as less meaningful for actual spending ("while low-frequency movements ... had been broadly associated with trends in consumer spending, there was little evidence ... that high-frequency movements carried much predictive content").

A month on, and that assessment may need to be tweaked. The starting point for consumer spending does not look as good, retail sales have continued to soften and consumer sentiment has failed to rebound.

While the monthly retail data and confidence fall can still be downplayed, the surprising consumer picture from the first-quarter national accounts would have been a major disappointment for the Reserve Bank. Not only did consumer spending post a lacklustre 0.5 per cent quarterly gain (well below the 1.2 per cent gain in retail volumes in the previous quarter and keeping the annual growth sub-trend at 2.8 per cent year-on-year) but household savings rates remain elevated, rising a touch from 9.6 per cent in the fourth quarter to 9.7 per cent in the first quarter.

One key implication of the high household savings rates is that the hoped-for 'wealth effect' from housing – whereby the wealth gains from rising house prices generate a lift in consumer spending over and above incomes – has not materialised. Although the Reserve is not counting on a big wealth effect (the forecasts in its May statement on Monetary Policy refer to an expected "modest decline in the household savings ratio") the size of consumer spending relative to the economy (it accounts for 53 per cent of GDP) means the marginal support from this "modest decline" is an important channel through which the housing upturn generates broader momentum. Dwelling investment alone accounts for just 5 per cent of GDP.

The Reserve Bank may view the absence of a wealth effect to date as a matter of time. There are also enough 'quirks' in the first-quarter national accounts to give pause to drawing strong conclusions from that quarter alone. Nonetheless the data will clearly make the Reserve Bank less confident about this aspect of the transition from mining investment to non-mining led growth.

To be sure, there have been some positive developments since the Reserve Bank’s June meeting as well. The first-quarter national accounts also showed a robust 1.1 per cent rise in GDP for the quarter, lifting annual growth to 3.5 per cent – a respectable above-trend growth rate in anyone's language even if over three quarters of it is coming from an improvement in net exports. The relative resilience of business confidence and reported business conditions following the federal budget suggests the sentiment hit has been confined to consumers and, as at May at least, had not seen a corresponding sharp drop-off in sales. The labour market has continued to hold up as well, with modest jobs gains over the last three months and the unemployment rate steady at 5.8 per cent (although we caution that underlying labour market conditions are considerably weaker than this measure indicates).

On housing, the cooling off evident earlier in the year and already noted by the Reserve Bank has continued. For the most part it still looks to be an orderly slowdown rather than a hard landing, and, from the point of view of price growth, something the Bank would likely welcome 
to some extent. Even though the slowdown has seen a sharp 14.7 per cent pull-back in monthly dwelling approvals since the start of the year, the very high starting point for approvals means robust growth in new dwelling investment is locked in for 2014 and early 2015.

Conclusion

While the Reserve Bank board's July policy meeting may be an uneasier one, concerns and uncertainty alone are unlikely to prompt a shift in policy stance. The Reserve Bank governor has made it clear in the past that he does not believe monetary policy can be fine tuned to achieve particular outcomes. Hence the board is unlikely to respond to the monthly 'ebb and flow' of economic conditions, particularly when it is unclear whether these will be sustained and when interest rates are seen to already be working appropriately.

More generally, the July meeting is not an appealing month timing-wise for the Reserve to signal a shift. The prospect of a quarterly CPI update and a statement on monetary policy to give a full discussion of the economic outlook tends to see August as a more favourable window for policy shifts. Indeed, if anything, the governor's statements accompanying Reserve Bank’s decisions in July are typically shorter as a result.

On top of this, next week alone sees key updates on retail sales, dwelling approvals, house prices and credit growth, with the July Westpac-MI consumer sentiment index due out a week later. These will provide critical evidence on whether there is a worsening shift happening domestically across the consumer and housing sectors.

On balance, we suspect any softness will be viewed by the Reserve Bank as a temporary lull, to which it will be reluctant to apply additional stimulus. Conversely, the still fragile consumer sector, the absence of a meaningful 'wealth effect' from the housing upturn, and the clear cooling off now underway in the housing market makes it difficult to envisage a situation in which the Reserve would be contemplating interest rate rises any time soon. Accordingly, we continue to expect interest rates to stay on hold through the rest of 2014 and much of 2015.

Matthew Hassan is a Westpac senior economist.