- Following the 27th consecutive Board meeting the cash rate remains at 1.5%;
- The RBA still expects the economy to improve, unemployment rate to fall and inflation to rise;
- But they have (modestly) downgraded their growth forecasts and acknowledged greater risks;
- The RBA looks to be still thinking that the next cash rate move will be up;
- But they also likely have moved closer to a more 'neutral' view on the interest rate outlook.
"Ah, is it just me or does anybody see, the new improved tomorrow isn't what it used to be''
'The More Things Change the More they Stay the Same', Bon Jovi
Surely one of the outstanding sing-out-loud bands of all-time has been Bon Jovi. From tough competition, 'It's My Life' is probably my favourite tune (although a Rolling Stone Readers Poll had 'Livin' on a Prayer'). Whatever. Virtually everyone can agree that Bon Jovi is one of the great bands, dominating the record charts for three decades and making the Hall of Music Fame in both the US and the UK.
One of their lesser-known songs was 'The More Things Change the More they Stay the Same'. While the song may not be as well known as some others the meaning is certainly widely understood. And the meaning sums up nicely what has happened in financial markets over the past year: views on the economic outlook have evolved but interest rates remain unchanged. Below is a summary of the RBA views on the economy and financial markets following their February 2019 Monetary Policy meeting and how that compared with their views following their meeting in February 2018.
Global Economy: More risks but room for optimism
There was a broad-based pick-up in the global economy in 2017. A number of advanced economies are growing at an above-trend rate and unemployment rates are low. Growth has also picked up in the Asian economies, partly supported by increased international trade. The Chinese economy continues to grow solidly, with the authorities paying increased attention to the risks in the financial sector and the sustainability of growth.
The global economy grew above trend in 2018, although it slowed in the second half of the year. Unemployment rates in most advanced economies are low. The outlook for global growth remains reasonable, although downside risks have increased. The trade tensions are affecting global trade and some investment decisions. Growth in the Chinese economy has continued to slow, with the authorities easing policy while continuing to pay close attention to the risks in the financial sector. Globally, headline inflation rates have moved lower due to the decline in oil prices, although core inflation has picked up in a number of economies.
The RBA was relatively optimistic at beginning 2018. Sure there were risks in China but the prevailing view was that the Government was on top of the situation. Fast forward twelve months. Economic momentum has slowed in each of the three major regions (the US, China and Europe). The Trade War has copped plenty of the blame (the RBA highlights trade in its Statement). And with global export volumes falling it is an issue. But focussing on the trade dispute means missing other important factors. In the US the economic slowing has been partly by design (higher interest rate, less fiscal stimulus). At the start of 2018 the Chinese Government was looking to achieve more sustainable growth (one with less pollution and less debt). More recently it has shown greater concern that the economy might be slowing a bit too much, hence the easing of policy. And Europe looks like it has been hurt by the weaker US and Chinese economies.
So as the RBA notes global economic risks have risen and economic growth forecasts have fallen. Analysts see the chance of a recession in the US within the next year being at its highest level since the GFC. This has led to the talk shifting from how high global interest rates may need to go to the possibility that central banks may need to again provide economic support. But it is too early to get too pessimistic. Unemployment rates in all major economies are lower than this time last year. Interest rates are still very low and few governments are in the mood to tighten the fiscal belt. Emerging markets (such as Brazil, Argentina and Turkey) had a tough 2018 but look to be through the worst. Sure a full-scale Trade War would not be good news. But a bigger Trade spat is neither in China's interest (weakening economy) or the US (2020 Presidential election). And even though a 'hard Brexit' is looking more likely, the fallout is most likely to be limited to the UK.
Key Chinese Economic Indicators
Economist Estimation of Probability of Recession US Economy Next Year
Change in Unemployment Rate Over the Past Year
Financial Markets: Greater recognition of risks, better value
Globally, inflation remains low, although higher commodity prices and tight labour markets are likely to see inflation increase over the next couple of years. Long-term bond yields have risen but are still low. As conditions have improved in the global economy, a number of central banks have withdrawn some monetary stimulus. Financial conditions remain expansionary, with credit spreads narrow.
Financial conditions in the advanced economies tightened in late 2018, but remain accommodative. Equity prices declined and credit spreads increased, but these moves have since been partly reversed. Market participants no longer expect a further tightening of monetary policy in the United States. Government bond yields have declined in most countries, including Australia.
The 2018 financial market story was (modestly) lower interest rates, widening of credit spreads and weaker equity markets. The slowing global economy (and the maintenance of low inflation) played a role. But valuations were also important. Credit spreads were too narrow and a number of equity markets (notably the US) too richly priced at the start of last year. This made them vulnerable as the Fed raised interest rates and the global economy slowed.
Valuations are now a bit better. Sure financial markets are not priced for a weak growth scenario but nor are they priced for blue-sky. Worries about market volatility is higher but that is no bad thing. The biggest problem for financial markets (and the global economy) remains the large runnup in debt that has taken place since the GFC. The most likely key trigger of any further major selloff remains higher interest rates.
Spread Between Long-Term Treasuries and Moody's Baa Bonds
US Equity Market Premia
Exchange Rate: Doing Its Job
On a trade-weighted basis, the Australian dollar remains within the range that it has been in over the past two years. An appreciating exchange rate would be expected to result in a slower pick-up in economic activity and inflation than currently forecast.
The Australian dollar has remained within the narrow range of recent times. The terms of trade have increased over the past couple of years, but are expected to decline over time.
In January the $A poked its head above 80c boosted by high iron ore prices and a narrow current account deficit. This would have worried the RBA concerned that a high exchange rate would offset the benefits of very low interest rates. But lower commodity prices (and relatively higher US interest rates) has seen the $A move back to a more comfortable level. The currency would currently rate low on the RBA's worry list.
The $A and BoQ of Fair Value Range
Business View About Exporter Sales (3-Month Average)
Domestic Economy: The music is still playing, but maybe not as loud
The Bank's central forecast for the Australian economy is for GDP growth to pick up, to average a bit above 3 per cent over the next couple of years. The data over the summer have been consistent with this outlook. Business conditions are positive and the outlook for non-mining business investment has improved. Increased public infrastructure investment is also supporting the economy. One continuing source of uncertainty is the outlook for household consumption. Household incomes are growing slowly and debt levels are high.
Employment grew strongly over 2017 and the unemployment rate declined. Employment has been rising in all states and has been accompanied by a significant rise in labour force participation. The various forward-looking indicators continue to point to solid growth in employment over the period ahead, with a further gradual reduction in the unemployment rate expected. Notwithstanding the improving labour market, wage growth remains low. This is likely to continue for a while yet, although the stronger economy should see some lift in wage growth over time. There are reports that some employers are finding it more difficult to hire workers with the necessary skills.
The central scenario is for the Australian economy to grow by around 3 per cent this year and by a little less in 2020 due to slower growth in exports of resources. The growth outlook is being supported by rising business investment and higher levels of spending on public infrastructure. As is the case globally, some downside risks have increased. GDP growth in the September quarter was weaker than expected. This was largely due to slow growth in household consumption and income, although the consumption data have been volatile and subject to revision over recent quarters. Growth in household income has been low over recent years, but is expected to pick up and support household spending. The main domestic uncertainty remains around the outlook for household spending and the effect of falling housing prices in some cities.
The labour market remains strong, with the unemployment rate at 5 per cent. A further decline in the unemployment rate to 4¾ per cent is expected over the next couple of years. The vacancy rate is high and there are reports of skills shortages in some areas. The stronger labour market has led to some pick-up in wages growth, which is a welcome development. The improvement in the labour market should see some further lift in wages growth over time, although this is still expected to be a gradual process.
The domestic economy entered 2018 doing well. A strong global economy was powering exports. Plenty of homes were being built because of a step-up in population growth. And the infrastructure boom was getting into full swing. Business confidence was rising leading to bigger capex budgets and more jobs. Consumers started to become more confident. Low wages growth was a worry, but has started to perk up (a little).
But it appears that firms were starting to become more worried as the economy travelled through 2018. The weaker global economy might have played a role. Confidence in the residential construction sector has taken a dip reflecting slowing sales and falling house prices. But it appears that confidence has declined across most industries (excluding mining).
But with interest rates low, the exchange rate a touch below average and some boost likely from fiscal policy it is also too early to get too pessimistic about the domestic economy. As always movements in the unemployment rate is the key indicator to watch. The unemployment rate declined over last year, and may fall a little further in coming months. How the labour market evolves over the next 1-2 years will play an important role in what happens with the cash rate.
Monthly Job Changes (rolling 12 -Month average change 000's)
Current State of Family Finances (6-Month average)
Firm Views About Business Conditions (3-Month Average)
AIG Construction Index (3-Month Average)
Inflation: The Long Wait Is Not Over
Inflation is low, with both CPI and underlying inflation running a little below 2 per cent. Inflation is likely to remain low for some time, reflecting low growth in labour costs and strong competition in retailing. A gradual pick-up in inflation is, however, expected as the economy strengthens. The central forecast is for CPI inflation to be a bit above 2 per cent in 2018.
Inflation remains low and stable. Over 2018, CPI inflation was 1.8 per cent and in underlying terms inflation was 1¾ per cent. Underlying inflation is expected to pick up over the next couple of years, with the pick-up likely to be gradual and to take a little longer than earlier expected. The central scenario is for underlying inflation to be 2 per cent this year and 2¼ per cent in 2020. Headline inflation is expected to decline in the near term because of lower petrol prices.
The latest data indicates that inflation is still under 2%. The hope has been that above average growth would eventually lead to higher prices. There are some signs that this has happened. Services inflation (excluding volatile items) has started to rise. The proportion of goods and services with falling prices has declined. Nonetheless, inflation has been under 2% for some time. And both consumers and firms do not expect any substantial rise of inflation any time soon. Any slowing in the economy would make the job of reaching the 2-3% inflation target a lot more difficult.
Headline CPI (Over the Year % Change)
Annual % Change Inflation (excluding volatile items)
Proportion of CPI Items
Consumer Inflation Expectations (3-mth avg, weighted mean)
Asset prices/Lending conditions: What a difference a year makes
Nationwide measures of housing prices are little changed over the past six months, with prices having recorded falls in some areas. In the eastern capital cities, a considerable additional supply of apartments is scheduled to come on stream over the next couple of years. To address the medium-term risks associated with high and rising household indebtedness, APRA introduced a number of supervisory measures. Tighter credit standards have also been helpful in containing the build-up of risk in household balance sheets.
The housing markets in Sydney and Melbourne are going through a period of adjustment, after an earlier large run-up in prices. Conditions have weakened further in both markets and rent inflation remains low. Credit conditions for some borrowers are tighter than they have been. At the same time, the demand for credit by investors in the housing market has slowed noticeably as the dynamics of the housing market have changed. Growth in credit extended to owner-occupiers has eased to an annualised pace of 5½ per cent. Mortgage rates remain low and there is strong competition for borrowers of high credit quality.
This is the area that has changed the most over the past year. It certainly has created the most headlines. House prices are now falling in Sydney and Melbourne (although are rising in some of the other cities). And 2019 is likely to be another tough year for Sydney and Melbourne house prices given the large amount of supply still to come. But some decline in house prices was necessary if affordability was going to improve. While the headlines have been about the problems of falling house prices consumer surveys indicate that Sydney real estate has started to become more attractive again. First-home buyers have returned to the market.
At the start of 2018 the RBA was happy that bank lending standards had been tightened. Now the worry is whether they have been tightened too much. Regulators have been worried that household debt was rising too quickly so some tightening in standards had to happen at some stage (although the RBA would also prefer that debt became more affordable because of higher incomes).
Australian Real House Prices (minus CPI, % change over year)
Consumer Views on Attractiveness of Sydney Property (6-Month average)
Firms' View On Net Borrowing Conditions (3-Month Average)
Proportion of Home Loans to First-Time Buyers in NSW (6-Month sum)
Interest Rates: Another Year of Inactivity
The RBA interest rate mantra over the past year is that the next move in interest rates is more likely to be up, but not for some time. A (basic) model for the appropriate level of the cash rate (based on something called the Taylor Rule that takes into account variables such as inflation and unemployment) suggests that the cash rate is currently around the right level.
The statement released following the Board meeting suggests that the RBA still thinks the next change in the cash rate is more likely to be up. But with the economic momentum slowing, growth risks rising and inflation under target the RBA might be starting to debate whether their 'tightening bias' should be removed back to a more 'neutral' stance. Certainly the RBA is unlikely to cut rates until there are clear signs that the unemployment rate is going up (barring a significant problem in financial markets). Indeed, if the unemployment rate continues to fall then the next move in interest rates will (eventually) be higher. But even then not until inflation sustainably moves above 2%.
Reflecting changing views on the economy, there has also be a change in views about monetary policy. Less analysts than this time in 2018 expect the next move to be up. And most of those that do expect less rate rises. There are also more people thinking the next move will be down. Indeed, there are broadly now as many analysts expecting the next rate move to be down as up over the next 1-2 years.
As always financial markets have moved early. At the time of writing, a bit under a 50% chance of one rate cut is priced by mid next year.
Australian Cash Rate V Taylor Rule
Probability of Expected Cash
So nothing has changed, but everything has changed. At the start of 2018 the cash rate was 1.5%. Most still expect that to be the case by end-2019. But changing economic views means it has started to become easy to envisage lower interest rates as well as higher ones. As always time will tell.
We live in interesting times!
Peter Munckton - Chief Economist