This week saw an as-expected RBA decision (a 25 basis point cut to 3.50 per cent), and two above-expectations data prints: Q1 GDP and May jobs. The expectations-beating data has seen market pricing pared back to be more in line with our rate expectations, which remain unchanged.
On the RBA, the June statement introduced a series of observations that suggest to us that the bank is prepared to cut rates further. On the international front, whereas in May the governor assessed that "financial market sentiment has generally improved", he now notes that: "financial market sentiment has deteriorated"; "spreads have increased"; and "long-term interest rates faced by highly rated sovereigns have fallen to exceptionally low levels". He also referred to a further weakening in Europe. Despite the poor payroll data for May, the governor continues to describe the United States as growing at a moderate pace, but does seem more concerned for Asia. A further moderation in growth in China is mentioned and the qualification used in the past – that this was "as intended" – is conspicuously absent. For the first time, the spectre of China's slowdown dampening growth in the rest of Asia was also raised.
Growth in Australia is now described as "moderate" compared to "below trend" in the May statement. While Westpac has consistently highlighted the impact of the cautious consumer on the economy, the bank has not always recognised this factor. However, in the June statement, the governor noted "both households and businesses continue to exhibit a degree of precautionary behaviour which may continue in the near term". Further, whereas in May house prices were described as "stabilising", one month on the governor points out that prices have "recently declined again". More generally, the housing market continues to be described as subdued. On the labour market, the governor looks to have taken little comfort from this, describing labour market conditions as having "firmed a little". Note, the April outcome has since been revised to 5.0 per cent, and the unemployment rate rose to 5.1 per cent in May.
From our perspective the most important observation is the governor’s assessment of the stance of policy. In May, interest rates to borrowers were described as "close to their medium term averages”. Explicitly talking of prior shifts (i.e. excluding the June cut) the bank describes them as "a little below their medium term averages”. This observation highlights the bank’s difficulties in getting traction from its policy instrument. Following the 50bp cut in May, the average standard variable mortgage rate (SVMR) fell by 35bps, blunting the potential impact. Post the June decision though, one major bank has announced that it will cut its SVMR by the full 25bps, while smaller institutions have offered a mixed response.
How the bank will interpret the apparent sharp uplift in real household consumption contained in the Q1 national accounts is a matter for conjecture. A speech delivered by the governor on Friday afternoon (so with the advantage of observing both Q1 GDP and the May labour force report) outlined a structural view that precautionary behaviour will remain in place until balance sheets are repaired. He argued that lower interest rates can accelerate the desired deleveraging at the margin, while calibrating the degree of the response to the inflation outcomes that cautious behaviour and balance sheet repair beget.
On the data front, the Q1 GDP print pointed to a surprisingly strong Australian economy in early 2012. Q1 GDP growth printed at 1.3 per cent for the quarter (4.3% for the year), well above market expectations of around 0.6 per cent.
The surprise was all in one component, household consumption. In contrast, residential investment, equipment investment, new building activity, public investment, exports, hours worked and the terms of trade all fell. None of these results are indicative of an economy where household expenditure surged a near-record 1.6 per cent.
The major contributors to the 1.6 per cent jump in growth in household consumption expenditure were: food (0.4ppts); transport services, essentially outbound tourism (0.2ppts), recreation and culture (0.2ppts) and insurance (0.2ppts). As we saw with the retail sales report for the March quarter, strong volume growth in retail sales was associated with price reductions, with the household consumption deflator flat for the period – note, the absence of inflationary pressures will give the RBA considerable flexibility.
Households increased spending in Q1 without any substantial reduction in the household savings rate, which inched lower to 9.3 per cent from 9.4 per cent. This was made possible by wage incomes growing at a seemingly unsustainable 2.5 per cent in the quarter, driven entirely by higher wages (employment was flat). Households are still looking to maintain a high savings rate, so prospects for the labour market will be critical. On this point, the May employment outcome was supportive, but the decline in hours worked and the unemployment rate uptick gave reason to question the strength in employment.
Growth across the states was extremely unbalanced with contractions in NSW, Queensland (on a pull-back in business investment), and Tasmania, while growth in WA was 7.8 per cent (yes, that’s for the quarter).
The Q1 GDP outcome will be a very difficult report for the authorities to assess. On the one hand, weak (non-mining) business investment, falling exports, and contracting commercial and residential building certainly justify the recent rate cuts. On the other hand, households appear to be taking advantage of price discounting, a very high AUD to travel, and a jump in wage incomes – a rate of increase which we assess to be unsustainable.
The RBA will be mindful that the March quarter coincided with a far more optimistic view on the international economy (US data surprised to the high side and the European crisis appeared to wane). This proved to be short-lived and very misleading and conditions globally have deteriorated rapidly through April and May.
It is our view that with global uncertainties weighing on confidence, national income crimped by a falling terms of trade, the housing sector in poor condition – with house prices continuing to contract modestly and jobs growth likely to falter – this burst of consumer spending is unlikely to be sustained. Accordingly, the recent rate cuts are fully justified and the need to go even further remains. The test now will be how forward looking the authorities are prepared to be in the face of this spending burst. We remain of the view that the cash rate will be lowered by a further 75bps by year end.
Bill Evans is Westpac's chief economist.