–  DECEMBER 2017 INSIGHTS BY THE CURVE TEAM –

Highlights

  • The cash rate remained at 1.50% for the entire calendar year in 2017 after the RBA left it unchanged again in December.
  • Monetary policy in a number of jurisdictions is likely to shift over the year ahead.
  • Domestically the RBA will be watching competing forces in the Australian economy.
  • How these two key trends evolve over the year ahead will go a long way to determining Australia’s monetary policy setting.

Rates Recap

  • The RBA left the cash rate on hold yet again in December with the cash rate remaining at 1.50% throughout 2017.
  • It is only the time in the modern monetary policy era that the cash rate has remained unchanged over a calendar year.
  • The longest stretch of rates on hold currently stands at 22 months.
  • In the post meeting statement Governor Lowe reiterated the Board’s confidence in their current forecasts while maintaining caution around the outlook for the consumer.
  • Elsewhere around the glove, the move away from emergency monetary policy settings is set to continue.
  • The FOMC is widely expected to lift the Fed Funds rate again in December.
  • The US yield curve has continued to flatten as the short end is rising on the expectations for rate cuts while the long end remains stubbornly low.

Key Themes for 2018

As another very interesting year draws to a close, it is a perfect time to look to the new year and what it might have in store. In this year’s December issue I thought I would take a closer look at two key themes that I think will impact monetary policy over the year ahead. There will of course be a multitude of things that will impact monetary policy so these are just two key ones I think warrant particular attention over the year ahead.

Unwinding of the Great Monetary Policy Experiment

This is more from a global perspective but is likely to have implications for Australia’s monetary policy. Over the past decade we have seen one of the greatest experiments in monetary policy in recent times. The use of quantitative easing.

Quantitative easing was introduced to provide additional monetary policy accommodation once interest rates reach or went below zero in a number of jurisdictions. While the success of quantitative easing is still up for debate, the fact that the reversal of these policies is happening is not.

The US has been the first to move in running down their balance sheet that ballooned following the GFC. In the early stages, the run off of assets accumulated over the past decade will be slow at first before, then gradually increase to a faster pace. This pace is expected to remain until the US Federal reserve’s balance sheet returns to a more normal level.

The other big exponents of the experiment are likely to follow suit eventually. The European Central Bank is about to start slowing their quantitate easing purchases soon. There are also signs that the Bank of Japan may announced a shift in policy away from yield curve management in the first half of next year. Add to that the Bank of England and the Swiss National Bank who also have bloated balance sheets and we could see a significant shift in the year ahead.

The implications of the unwinding of these policies, much like their implementation in the first time, is largely unknown.

The slowing of purchases and outright selling of assets could change the supply/demand dynamics over time which would then in turn effect the price of those assets. In other words, where the underlying assets are bonds for example, all other thing being equal, if there is less demand for any given level of supply, the price would fall. When the price of a bond falls, the yield rises due to the inverse relationship between price and yield.

Another impact could be on liquidity levels globally. If central banks stop buying assets and start selling, they are effectively draining liquidity from the financial system. This could have even more widespread ramifications that the potential increase in bond yields. Much of the liquidity pumped into financial markets has found its way in to other asset classes.

2018 could prove to be once of the most interesting years for monetary policy watchers since the GFC.

Investment vs Consumption

This battle will be crucial to the outlook for monetary policy in the year ahead. Those who have follow the Curve Team’s commentary throughout the year would be well aware of these two underlying trends within the Australian economy. They are also the two key themes that bulk of the RBA’s communiques revolve around.

The RBA’s long held desire that non-mining investment would eventually come to the fore in the aftermath of the mining investment boom is starting to finally materialise. This is in part due to interest rates being held at record lows for so combining with a sustained uplift in business confidence and conditions. It is also in part due to a huge pipeline of government infrastructure getting underway.

This hope is that this non-mining investment boom will underpin employment growth and eat into the current slack in the labour market. As slack in the labour market starts to disappear it is expected to lift wages and thus boost inflations.

So far the uptick hasn’t quite been enough and consumers are starting to feel the pinch. An extended run of sub trend growth and slack in the labour force has seen wage growth slip to record low. While consumption had held up well in the fact of slowing wage growth with help from the falling savings rate, consumers are starting to feel the pinch.

The latest national account for the third quarter revealed that household consumption grew an anaemic 0.1% for the quarter. This is the lowest quarterly increase since the GFC. The worrying sign is that the house prices increases over the past 5 years has shown little in the way of a wealth effect and it now looks like the run up in prices is over for now.

The big question for the year ahead is will the pick up in investment be enough to offset the ailing consumer?

Outlook for Interest Rates

The past year is only the third occasion that the cash rate has gone a whole calendar year unchanged. That takes the current stretch of rates on hold to 16, which should become 17 in the new year as the RBA doesn’t meet in January. If the RBA leaves rates on hold throughout the first half of 2018, we will equal the longest run of rates on hold in the modern monetary policy era.

There is every chance that we see a repeat of the past year and the cash rate remains on hold for a second consecutive year and in the process, set new record. Current market pricing only has a 2 in 3 chance of a 25bp increase the case rate factored in by year end.

The RBA’s current expectation is that growth will continue to gradually improve and which will slowly lift inflation back towards the target band. Those expectations are based on a number of assumptions, one of those being that the cash rate moves broadly inline with market pricing as seen in the chart. At the time of its last forecasts, the market had a hike priced in by the end of the year.

How the two themes outlined above evolve over the year ahead will go a long way to determining what happens to monetary policy in Australia in 2018.

The movement away from emergency settings of monetary policy by a number of the major central banks around the globe could have implications for monetary policy in Australia. The US, Canada and Bank of England have already lifted rates. While these central banks are lifting rates off a lower base than Australia, narrowing interest rate differentials could have implications for the AUD.

While the RBA wouldn’t be too worried if the AUD were to head a little lower, any substantial move lower could be more problematic. This will be important for the RBA given the AUD’s roll in the overall calibration of monetary policy. A lower currency has a stimulatory effect, something if which becomes to large, could require offsetting.

The unwinding of quantitate easing also poses risks. One risk is that is also effects interest rate differentials The other is that the removal of liquidity from the global financial system results in increase volatility in financial markets. Exactly what impact this could have is largely unknown.

The other big unknown is how the dichotomy between investment and the consumer evolves. If the RBA is right and the increase in growth slowly lifts wages and inflation, then the cash rate is likely to move in line with the markets expectations.

If the increase in investment gathers pace or combines with offshore pressures, they that could see the risk of higher interest rates become a greater probability as the year get on. Alternatively, if central banks drag their feet and the slump in consumption continues then there is a greater risk that the RBA sits pat for an extended period.

The risk of lower rates remains a low probability but not zero. Governor Lowe himself only recently indicated that the next move is likely to be up. In the absence of economic shock, either domestically or internationally, this is likely to be the case.

While there are a lot of prevailing risks to the upside and downside, which could see expectations for the cash rate swing throughout the year, I see the current market pricing as a fair representation of where monetary policy is likely to head next year. However with a wide variety of outcomes possible from the two trends outlined above alone, anything could be possible in 2018. Stay tuned!

Australian Economic Highlights

  • Growth for Q3 came in a 0.6%, short of both the market and RBA’s expectations. The annual rate lifted from from 1.9% to 2.8% after the negative read from last year dropped out of the calculation. However the market and RBA were expecting an increase to 3%.
  • CPI continued to disappoint,  the headline figure only lifting 0.6% for Q3 with falls in fruit and vegetable and telecommunications prices contributing largely to the weakness. The RBA’s preferred measure, core inflation also remained below the band at 1.88% after a quarterly increase of only 0.35%.
  • Employment data remained reasonably robust in October. The unemployment rate dipped another 0.1% to 5.4% despite a weaker than expected increase in jobs of 3,700 thanks to fall in the participation rate. 
  • The ANZ job ads report continues to suggest that employment growth will remain solid in the months ahead, with a second consecutive lift of 1.5% in November.
  • After hitting a record high last month, the NAB business conditions index eased back from 21 to 12 as profitability and trading conditions eased back. Index is still well above long run average of 5. The Business confidence index should be closely watched as it continues to drift lower. After rising to a recent high of 14 in April it is now back it its long run average at 6.
  • Consumer confidence continues to languish as weak wages growth and tightening credit standards continue to impact family finances. The index slipped back below 100 in November, falling 1.7% to 99.7.
  • After a very weak run, Retail sales showed some signs of lift, rising 0.5% in October. It comes off the weakest quarter of consumer activity since the GFC according to the Q3 national accounts.
  • Housing finance continues to be impacted by the macro prudential restrictions imposed by the council of financial regulators. Both the number and value of commitments for owner occupiers was down again in October while Investors posted a small lift after a solid fall in recent months.
  • Australia’s trade surplus fall but evaporated in October, falling to $105m. Falling prices and volumes hit commodity exports while imports higher. Fuel imports accounting for almost half the increase.  
  • Building approvals remained stable in October with a small increase of 0.9%. The reinforces the recent trend seen throughout the year after their sharp fall in late 2016.  
  • Motor vehicle sales too remain quite stable and were unchanged in October from a month earlier. 
David Flanagan

David Flanagan

Director Interest Rate Markets