• The RBA cut rates by 0.25%, taking the cash rate to 1.25%;
• This was the first cash rate change in almost 3 years;
• There were surprising few changes to the statement accompanying the announcement;
• Given the state of the economy, another rate cut is likely over the next few months;
• Financial markets have fully priced another cut, as well as a good chance of a third.
“(Full speed ahead Mr Parker, full speed ahead)
Full speed ahead it is, Sergeant
Action station, action station’’
You know you have made it as a band when there is a song titled, ‘Bigger than the Beatles’. The Beatles are not only the biggest selling music artists of all-time, they had more number one hits than any other band. All four band members were inducted in the rock and roll hall of fame. And they were so big that the band had a role in five motion pictures. By these lofty standards, Yellow Submarine was not one of the headline grabbers. That said, the song did reach number one in the UK for 4 weeks (and number 2 in the US). The Beatles said they wrote it as a children’s song (I can remember singing it in primary school). That did not stop the song attracting differing social interpretations.
One of the references in the song was to ‘Action Station’, a call by the Royal Navy to sailors when facing an emergency. Managing the economy certainly doesn’t have the same urgency (or potential implications) as those working in the navy. But after (a record breaking) 34 months of unchanged policy the RBA has shifted to actions stations, reducing the cash rate to 1.25%. Why the change in direction? The economy shifted back from full-steam ahead in the first half of last year to its current half-speed pace. This change reflected both global factors (slowing Chinese and European economies, a growing trade dispute) and home-grown ones (a weaker housing market impacting manufacturer’s and retailors). Inflation has also dropped a notch
For a while the RBA was puzzled by the mixed messages sent by a strong labour market and soft GDP numbers. But if the economy is softer enough for long enough jobs start to become less bountiful. The RBA noted the recent tickup in the unemployment rate. And once the economy loses some vim, firms become more reluctant to raise prices and consumers have a sharper eye for bargains (making it harder to increase inflation).
The obvious question is can the cash rate go lower still? There are a number of reasons to think it can. The global backdrop is not great. The Chinese economy while regaining some of its lost mojo has (not yet) been able to get rollicking like the days of old. The combination of a softer Chinese economy and the Trade Dispute has meant trade-exposed sectors globally (notably manufacturing) are struggling. Ditto economies most closely tied into global trade (Asia, Europe). The RBA noted the downside risks.
The global economic news is not all bad. Unemployment rates are low in many countries, wages growth is (slowly) rising. Consumers are spending, service industries in most countries are doing Ok. But investors are putting more weight on the negative (and is the reason why German bond yields for example recently moved back below their record low level). A resolution to the trade dispute would be a big help (something that unfortunately seems to be getting further away). The global economy is doing better than the headlines suggest. But it needs to do better still.
World Business Surveys
German 10-Year Yields
Domestically, we are in the early stages of the downturn in the residential construction cycle. Australia did not build enough residencies in the early part of this decade as population growth boomed. But we have certainly made up for that inactivity in recent years (notably multi-story units), with an oversupply developing in a number of areas (evidenced by declining rents and falling house prices). Economics 101 is that lower prices leads to lower supply, and the number of building approvals has been dropping sharply. So while there is still a bit of work in the pipeline for builders yet to do, residential construction will be a negative for economic growth over the next 2-3 years.
The slowdown of residential construction and weaker global economy has led to a downturn in business sentiment. And this is leading to firms scaling back their capex and hiring plans. There has been plenty of discussion about the ‘puzzle’ of weak wages growth. But a fair bit of that puzzle can be explained by the jobs market having not being strong enough for long enough.
Number Of Dwelling Units Approved
(3 month average)
Firms Views On Capital Spending
(3 month average)
Job Ads As Proportion Of Labour Force
Underutilisation Rate & Wages Growth
The interest rate cut will help. But not to the same extent as in the past. Interest rates were already at unusually low levels, so a quarter percentage point reduction can only do so much. Lower rates will help households service their debt. But many households keep the size of their payments unchanged when mortgage rates decline. So lower interest rates doesn’t translate into more disposable income for spending (but it does boost their housing wealth and help them reduce their debt quicker). And for savers lower interest rates leads to lower disposable incomes.
Household Interest Payments Ratio
(interest payments to household disposable income)
Wisest Place For Saving - Payoff Debt
SMSF Allocation To Cash
Consumer Interest Receipt Ratio - % Of GDP
It is not all negative. Infrastructure spending will be strong for some time. The promise of lower interest rates has already resulted in a weaker $A, not only against the $US but against all of our major trading partners. Overseas buyers purchasing Australian goods and services are now getting extra bang for their buck (yen, RMB or Euro). The currency market is already assuming that the RBA will cut rates to (at least) 1%. So a further fall in the $A will require investors to expect more than two further quarter percentage point reductions in this cycle.
Another (potential) positive is that the economy can get more help from government (fiscal policy). Much of the recent public discussion has been about the need to return the budget to surplus. And given the flood of revenue into government coffers over recent times that is understandable. But fiscal policy as a means to boost the economy comes into its own in a world of very low interest rates. A rule of thumb is that (like now) governments should think about borrowing when the interest rate they face is less than national income growth (ideally the borrowings should be for a long period of time and used to invest into productive assets to boost long-term economic growth).
Change In Australian Dollar
(annual % change real TWI)
Difference Between National Income Growth & Australian Government 10-Year Bond Yield
Capex spending by miners won’t be the same negative it has been in the years post the mining boom. Capacity utilisation in the mining sector is above average and could move higher yet as China looks to boost its economy. When commodity prices were lower miners cutback their capex spending to reduce costs. Now that times are better miners capex budgets need to rise again so they can at least maintain their rate of production.
And there are even (some) positives for the consumer. Wages growth has been (inching) higher. Inflation has been moderating. The result is that workers pay packets now can go a little bit further (rising real wages). Add in the looming tax cuts for low- and middle-income earners and the lot of many householders is looking that little bit brighter. That said, the RBA still thinks the consumer is the main worry for the domestic economy.
Mining Sector Capacity Utilisation
Annual Real Wages Growth
(hourly play excl bonuses minus headline CPI)
Finally, the tone of news stories on housing has changed over recent weeks (although the positive sentiment has yet to translate into more Google searches for housing finance). The RBA noted that there have been some signs the decline in house prices may be bottoming. Given the amount of supply that is hitting the market it is hard to become very positive on (most) housing markets for the next year, or two. But recent developments should mean that some of the more dire scenarios for housing will become less likely.
Search Term 'Housing Finance'
(12 month average)
So there are the pluses and minuses. The indicators that tend to lead the economic cycle suggest that the balance of evidence favours the minus camp. Going the other way (and despite the popular view) the run of economic data over recent weeks has actually been stronger than expected.
Australian Leading Economic Indicators
(annual % change)
Economic Surprise Indicator Australia
(4 week average)
Financial markets have looked at the evidence and decided that more rate cuts are needed. At the time of writing they have fully priced an additional cut by end Q3 and moved to heavily price in the chance of a third reduction by the first half of next year. Most economists are on board with the need to take the cash rate to 1% (there is some disagreement about the timing). Fewer have signed up to the necessity of taking rates to under 1% (although that number is growing). The economic data does not currently provide the evidence for more than two rate reductions. Those making the argument that the cash rate needs to fall under 1% are assuming that things will get worse from here (which is possible). In that scenario the global economy will be the most likely culprit.
Australian Cash Rate Outlook
(as at 4 June 2019)
Australian Cash Rate V Taylor Rule
The rate reduction by the RBA is not quite ‘Bigger than the Beatles’. But it certainly is big news for the domestic economy. The RBA has kept their economic growth and inflation forecasts unchanged. For the economy to achieve those forecasts the RBA will need to remain in Action Stations mode. Help (in the form of fiscal easing or a resolution to trade disputes) would also be a big help.
We live in interesting times!
Peter Munckton - Chief Economist