WEEKEND ECONOMIST: The credit conundrum

We have prepared a 30 page document for our US customers which I will be presenting on my marketing trip over the next two weeks. Below I have set out the executive summary. Note that we have maintained our call that the RBA will be tightening by 25 basis points on March 2 with a goal to return the cash rate to the "new neutral" of 4.5 per cent by July.
The Australian economy has shown remarkable resilience through the aftermath of the Global Financial Crisis. The unemployment rate peaked at 5.8 per cent and has recently fallen to 5.3 per cent. That is only 0.3 per cent above the likely unemployment rate below which wage and price pressures have lifted markedly in earlier cycles. This recovery in the labour market is supporting household incomes and consumer confidence.

In addition sharp reductions in interest rates and a generous First Home Buyers Grant have rejuvenated the housing construction industry. Finance approvals for new construction have nearly doubled over the course of 2009 and dwelling approvals are up by 53 per cent. A surge in dwelling construction will contribute more than 1 percentage point to economic growth and support strong growth in spending on household goods.

Capacity utilisation has increased sharply recently pointing to a recovery in equipment investment while the well documented mining boom will see mining investment increase from 1 per cent of GDP in 2000 to nearly 5 per cent in 2011. Final demand is forecast to grow by 4.5 per cent in 2010 and 3.5 per cent in 2011 up from 1 per cent in 2009. Commodity prices are also forecast to rise over the course of 2010 and 2011. We estimate that by the end of 2011 Australia's terms of trade will be restored to the extraordinary levels which were experienced prior to the liquidity crisis in 2008. The boost to incomes from a rising terms of trade will complement the impact from rising employment.

The positive outlook for commodities is underpinned by our view that the surge in industrial production in China; India and other emerging nations will largely offset the ongoing weakness in the advanced economies. Global activity is expected to return to long run trend by 2011 despite continuing weakness in the advanced economies.

This growth profile will pose some challenges for the domestic monetary authorities since Australia is entering this upswing with much less spare capacity than had been expected six months ago. The overnight cash rate is likely to be increased gradually most likely beginning in March until it reaches 4.5 per cent by the September quarter. A delay in March would most likely be caused by a further deterioration in global financial conditions as the authorities fear contagion to the Asian region. An extended pause is then anticipated until the authorities become more comfortable with growth prospects in the advanced economies and the state of the global financial markets. There will be no need for the authorities to move above the "neutral" 4.5 per cent until it feels confident to raise its current growth forecast of "trend" in 2011 and 2012. A neutral cash rate, trend growth and inflation holding in the target band seems an attractive equilibrium to justify an extended pause. A quick move into contractionary policy would only be precipitated if the unemployment rate fell more rapidly than we currently forecast.

Likely headwinds which will face the Australian economy through 2010 and 2011 will relate to the availability of adequate credit to finance activities associated with rising confidence. The authorities are already perplexed by the sharp contraction in overall business credit and the flat performance of credit to the small business sector. Australian banks are challenged by increasing funding costs and the threat of over-regulation. Draft liquidity guidelines being proposed by BIS would (even if only partially implemented) pose a serious threat to the free flow of credit in the Australian economy. Uncertainty about liquidity and funding issues through the course of 2010 will constrain the supply of credit. Coupled with disappointing news on the pace of recovery in the advanced economies the Australian authorities are likely to refrain from raising their growth and inflation forecasts for 2011 therefore avoiding the need to increase rates above the neutral level of 4.5 per cent.

We are pessimistic about growth prospects in the US, Europe and Japan. Underlying growth of final sales in the US in the second half of 2009 is running at "only" 2 per cent of which 1–1.5 percentage points is due to the indirect effects of government stimulus programs. With the fiscal stimulus fading by mid year and Fed liquidity programs, particularly with respect to mortgage securities ceasing by April, underlying growth in the US is likely to fade significantly. Bond markets will reflect relative growth outlooks. The spread between Australian bond rates and US rates is likely to widen significantly over the next few months. Risks to this outlook are not in Australia. Investors in US bonds should focus on yawning output gaps; annual core inflation falling well below the Fed's preferred 2 per cent; and a general acceptance that under a standard Taylor Rule the federal funds rate would be -1 per cent to -3 per cent. Unfortunately they may focus on huge budget deficits and the dramatic expansion of the Fed's balance sheet and stoke up inflationary expectations. The only possible policy response from the Fed would be "tough talk" which may discourage significant reductions in US bond rates.

The definitive change in market relativities will occur when signs of a sustained recovery in the US are more convincing. We do not envisage that until 2011. The early stages of the Fed's tightening cycle will be hugely significant. Bond spreads will narrow and the USD will be supported.

In the near term we see the dominant driver of currency sentiment to be fluctuations in risk perceptions. Concerns with sovereign risk both in Europe and individual states in the US will discourage risk investors for the next 3–6 months. Disappointment in the pace of recovery in the US and European economies and uncertainty about the policy adjustments in China will also pose headwinds for risk seekers. That period will favour the USD and the Yen.

However as markets become more comfortable that the Chinese authorities will not "overtighten" and anticipate an improving outlook for the advanced economies in 2011 risk investments will regain favour. The Australian and New Zealand dollars are likely to be significant outperformers during that period. We expect the AUD to move from an "undervalued" 85¢ to 95¢ by year's end.

Bill Evans is chief economist at Westpac.