• The RBA elected to cut the cash rate by 25bp in August, taking it from 1.75% to 1.50%.
  • Enduring structural change in the employment market is keeping a lid on inflation.
  • Market pricing and the RBA’s forecasts suggest the easing cycle might not be finished yet.
  • The FOMC still has the desire to lift rates despite with the recent bounce in employment giving them a small window which could help the RBA.

Rates Recap

  • Another quarter of soft inflation resulted in the RBA electing to cut the cash rate in August with the move widely expected.
  • Governor Glenn Stevens’ accompanying statement outlined the ongoing challenges for monetary policy – however failed to commit to an explicit easing bias.
  • The subsequent quarterly Statement on Monetary Policy shed more light on the decision to cut and the outlook for the cash rate.
  • A second solid nonfarm payrolls report has given the FOMC to a small window to raise their benchmark interest rate.
  • Despite increased expectations of a FOMC hike, yield curves globally continue to flatten with our own 10 year government bond hitting another record low.

Wages A Drag On Inflation

The Australian economy finds itself facing an ongoing conundrum. Growth is running slightly above trend according to GDP figures over the past couple of quarters. The economy continues to rebalance towards no-resource sectors thanks to lower rates and the depreciation of the Australian dollar. The employment market is holding up well, as is the housing market, and financial markets are behaving quite well. Yet we find ourselves with a cash rate that has hit yet another record low after the RBA cut it a further 25bp in August to 1.50%.

The problem that Australia – like the rest of the world – faces is a distinct lack of price pressures and inflation across the economy. There are a wide range of factors at play, however, one that stands out in Australia stems from the employment market. Despite overall jobs growth holding up over the past six months following strong growth in 2015, the structural shift towards a more flexible workforce is driving up underemployment and underutilisation. Assessing the momentum of the labour market in its forecasts, the RBA’s Statement on Monetary Policy released last Friday stated:

It is possible that the recent decline in employment growth was temporary, in which case, employment growth would recover more quickly than is currently forecast. However, to the extent that gains in employment continue to be mostly in part-time employment and among workers who would like more hours, there could be more spare capacity in the labour market than implied by the forecast for the unemployment rate.

The RBA outlines two mark factors behind the ongoing structural shift towards part time employment. The first is that employment growth has been stronger in household services and tourism, which traditional have a higher proportion of part-time employment. This should come as no surprise as these are the industries that the RBA has been looking towards to fill the gap left by mining. The second is far more instructive of the lack of price pressures that are emanating from the low wage environment. The second factor, according to the RBA:

may reflect a cautious approach by firms to hiring and/or a means for them to increase their use of labour in a way that contains costs. In particular, the Bank’s liaison suggests that a broad range of businesses are seeking greater flexibility from employees through the use of part-time or casual work or temporary contracts, to improve productivity and minimise their labour costs.

The impact this is having on wage growth is just one phenomena that is currently working against the RBA and keeping a lid on inflation. Until the economy can absorb the excess capacity in the labour market and put some pressure on wage growth, it is likely we will continue to see weak inflation.

Outlook for Interest Rates

The RBA once again gave little away around the outlook for interest rates following its decision to cut the cash rate in August. This left the market to sit tight until the Quarterly Statement on Monetary Policy was released last Friday. There is plenty of quality information contained in the 72 page document from the RBA. Despite the pages and pages of analysis, there is very little that has changed, with the RBA summing up its new forecasts for growth as follows:

There has been very little change to the outlook for economic activity since the previous Statement. GDP growth is expected to be around 2½–3½ per cent over 2016, before increasing to around 3–4 per cent by 2018, which is above estimates of potential growth in the Australian economy.

With inflation being so pertinent to the outlook for interest rates, there was a little considerably more colour on the outlook for price pressures:

Underlying inflation is expected to remain around current rates in the near term, before picking up gradually to around 2 per cent by the end of the forecast period. The substantial depreciation of the exchange rate over recent years is expected to continue exerting upward pressure on the prices of tradable items for some time. Wage growth is expected to remain low in the near term, before rising modestly over the forecast period as labour market conditions improve and the adverse effects of the decline in the terms of trade and mining investment wane. There is, however, considerable uncertainty about the timing and the size of these effects.

The situation hasn’t really changed since the RBA’s May statement, which also followed a rate cut. The RBA’s forecasts still don’t see inflation returning to the bottom of the band until at least the end of the forecast period in 2018 – at best. Under the assumptions that go into the forecasts, the exchange rate remains constant and the cash rate moves roughly in line with market expectations at the time that the forecasts are made.

The chart on the right shows that the market was still pricing in a further rate cut following the August move to 1.50%. This means that even with another rate cut, the RBA is still only expecting the RBA to get to 2.00% by 2018. This indicates that unless we see the Australian Dollar depreciate, which is entirely possible should the FOMC finally hike rates again, then we will see another rate cut by the RBA. Even if the economy outperforms the already sanguine outlook for growth that the RBA has, they are likely to let the economy run hotter for longer to ensure inflation returns to the target band.

Australian Economic Highlights

  • Growth managed to beat expectations in Q2 with GDP rising by 1.1%, up from 0.7% in Q4 with the annual rate firming from a revised 2.9% to 3.1%. Domestic demand was subdued with net exports accounting for over 90% of growth in the quarter.
  • CPI rose in line with expectations in Q2. Headline inflation was up 0.4% after the 0.2% fall in Q1. The core rate was also in line with expectations, rising by 0.45% with the annual rate of underlying inflation easing slightly to 1.5%.
  • The softer tone to the employment data re-emerged in June with total employment growth of 7,900 jobs with another big swing towards part-time employment. The weaker growth saw the unemployment rate drift up to 5.8% even with a 0.1% fall in the participation rate.
  • Signs of instability resumed in the ANZ job ads report in July with jobs ads falling 0.8% for the month after last steady gains in recent months.
  • NAB business conditions pulled back in July, falling from 12 to 8 with all of the subcomponents easing over the month. Business confidence was also weaker with the index slipping from 6 to 4. The employment index managed to hold on to last months gain, holding steady at 4.
  • Consumer confidence eased slightly again in July with the index dropping 1% to 102.2. This is a good result following the rate cut inspired jump of 8.5% in May. It could be short lived given the narrow victory of the Coalition in the federal election.
  • The lull in retail sales continued in June with a 0.1% increase falling short of expectations while the previous months result was unchanged at 0.2%. Retails sales ex inflation were a sluggish 0.4% for the quarter.
  • Housing finance was mixed in May with the data continuing to show little direction. The number of owner-occupier loans were down 1%, slightly better than the expected -2%.
  • Growth in outstanding credit posted an unusually small rise according to the RBA’s credit aggregates in June.  Housing lending continued to chug along while personal and business lending both fell in June.
  • Australia’s trade deficit continued to deteriorate again in June. The trade deficit widened to $3.2bn ahead of expectations of $2.0bn while the previous months $2.2bn was revised up to show a $2.4bn deficit.
  • Building approvals fell again in June, down 2.9% after they were expected to bounce back. The annual pace of building approvals still managed to improve from -9.2% to only be down 5.9%.
  • Motor vehicle sales bounced back in June with total sales up 3.1% from the previous month. Passenger vehicles led the bounce while SUV and other vehicle sales declined.
David Flanagan

David Flanagan

Director: Interest Rate Markets