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Australia & New Zealand Weekly: RBA’s Likely Rate Cut Strategy

Week beginning 11 March 2019

  • RBA’s likely rate cut strategy.
  • Australia: Westpac–MI Consumer Sentiment, housing finance, NAB business survey, RBA Deputy Governor Debelle speaks.
  • NZ: retail card spending.
  • China: fixed asset investment, retail sales, foreign direct investment.
  • Europe: CPI, industrial production.
  • US: CPI, retail sales.
  • Key economic & financial forecasts.

Information contained in this report current as at 8 March 2019.

RBA’s Likely Rate Cut Strategy

This GDP print for the December quarter of 2018 shows the Australian economy having slowed in the second half of 2018 from a 4% annualised pace in the first half to a 1% annualised pace in the second half.

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The challenge for the Reserve Bank will be to credibly maintain its GDP growth forecasts at 3% in 2019 and 2.75% in 2020. Expecting a lift in the growth momentum from 1% to 3% could only really be justified if the economy was expecting to benefit from a significant stimulus. But global growth is slowing; the residential construction cycle has clearly turned; the AUD remains in a stable range; monetary policy is on hold and fiscal policy will continue to be constrained by the perceived need of both political parties to predict a surplus in 2019/2020.

Consequently the Reserve Bank is likely to see the need to further revise down its growth forecasts when it announces its revised forecasts in the May Statement on Monetary Policy.

Those are likely to have an upper bound of 2.75% in 2019 and 2.5% in 2020. That is a “trend” forecast for 2019 and slightly below trend in 2020. Such forecasts are likely to still be assessed as consistent with steady policy with a clear “easing” bias.

With the residential construction cycle now turning down; business investment mixed; the savings rate now edging up; and house prices and new lending contracting, prospects for being able to maintain those forecasts in August look bleak. We expect by the August Statement on Monetary Policy, the growth forecasts for both 2019 and 2020 will have both fallen below potential (2.75%), probably not to Westpac’s current forecasts of 2.2% in both years but sufficiently below trend to invalidate any forecast of a falling unemployment rate and solid wages growth.

In such circumstances, with 150 basis points of “flexibility”, the RBA is expected to cut the cash rate by 25 basis points to 1.25% and follow that up with a second cut of 25 basis points in November recognising confirmation of persistent below trend growth. Under such a benign growth outlook it will also be necessary to further push back on the expected timing of the return of underlying inflation into the 2–3% target band.

This expected scenario is consistent with Westpac’s forecast for two rate cuts in August and November.

There were a number of significant developments in the GDP report.

Firstly we saw an extension of the contraction in new dwelling construction from the September quarter following a particularly strong first half. Westpac expects this is the start of a long run of falls in residential construction reflecting the downturn in dwelling approvals and an expected further contraction as tight funding conditions and falling house price expectations deter both demand and supply of new construction.

Secondly, we saw a second particularly weak print on consumer spending (0.4% following 0.3%) reflecting weak income growth and some early signs of a negative wealth effect as the savings rate lifted from 2.3% to 2.5%. Wages growth is lifting only very slowly while employment growth is expected to slow in 2019 as political uncertainty, global tensions around trade and softening demand weigh on business employment and investment intentions. There are lags but the tepid growth in the second half of 2018 is likely to weigh on employment growth in 2019.

There is also likely to be a further wealth effect on consumption as the impact of falling house prices on household balance sheets plays out. Evidence of a wealth effect during the boom period for house prices is apparent in the 1.7–1.9 ppt fall in the savings rate in NSW and Victoria. We expect this to gradually unwind over 2019 and 2020 restraining annual consumption growth to around 2.0% in both 2019 and 2020 with an expected lift in the savings rate from 2.5% to near 5% by end 2020. That rise in the savings rate and associated low consumption growth is the main factor behind the expected soft GDP growth outlook.

House prices will be important in 2019. Even though prices have fallen by 13% from their peak in Sydney and 10% in Melbourne, these adjustments follow cumulative increases of 60% and 44% respectively over the previous four years. Affordability is still stretched in both cities.

Unlike previous cycles where affordability was improved through sharp reductions in interest rates and relatively firm income growth, the necessary restoration of affordability in this cycle will need to come from prices. We estimate that further falls of 10% or more in these cities (over 2019 and 2020) will be required to restore affordability given limited interest rate flexibility and a restrictive credit environment. In previous housing downturns interest rates played a critical role in restoring affordability. With the RBA cash rate already down at 1.5%, there is very limited scope for interest rate cuts to perform that traditional role.

As we have recently seen in Perth, affordability can be restored but prices can still fall further if credit is tightened. While there is some unease in official circles around a possible credit squeeze we expect that the regulators will be comfortable to maintain greater scrutiny on lending practices. This is despite decisions by the regulator to release previous policies to limit inves