FEBRUARY 2017 INSIGHTS BY THE CURVE TEAM –

Highlights

  • The RBA left the cash rate on hold again in February at 1.50% after cutting by 0.25% in May and August last year.
  • Despite the unexpected fall in GDP in Q3, the RBA remains optimistic.
  • Their latest forecasts see growth bouncing back to 3% and accelerating by the end of the forecast period.
  • Any miss from growth over the first half of this year could leave the RBA stuck between a rock and a hard place.

Rates Recap

  • The RBA left the cash rate on hold for the sixth straight month in February after lowering it at both the May and August meetings last year.
  • Governor Lowe and the RBA Board continue to expect growth to pick up and inflation to return to the target band over time.
  • The sharp decline in GDP in Q3 has seen the RBA downgrade their near term forecasts.
  • After rising following the US Presidential elections, longer term rates were largely unchanged over the past month.
  • The FOMC didn’t follow up their December hike with another at their most recent meeting.
  • If they fail to go in March, median expectations for three hikes this year could be a stretch.

RBA Holds Steady

The RBA held the cash rate steady for a sixth straight month in February as was widely expected. The RBA also indicated that there was no material change to their medium term forecasts, despite the unexpected weakness in key data releases since their previous forecasts in November were released.

This fact was clarified with the release of the quarterly statement on monetary policy which said that:

“As a starting point for the forecasts, GDP fell in the September quarter, which led to a marked decline in year-ended growth of the Australian economy. Some of the factors weighing on reported GDP growth in the September quarter were temporary and have not materially affected the outlook for growth.”

The RBA’s outlook for the medium term sees the Australian economy growing at around 3%, which would be just above what is now to be perceived as the trend rate of 2.75%. So as we can see in the first chart on the right is, once the RBA’s forecasts have been adjusted for the ‘temporary’ fall in growth from the third quarter of last year, growth will pick back up to 3% over the medium term. Growth is then expected to accelerate above 3% in 2019. That acceleration in growth in the longer end of the forecasts has also been trimmed compared to previous forecasts.

The outlook for growth is important as it is tied into the outlook for inflation. According to the RBA’s Statement on Monetary Policy:

“Measures of underlying inflation are forecast to pick up gradually, to be around 1½–2½ per cent by the end of 2017 and 2–3 per cent by the end of the forecast period. Headline inflation is expected to increase to around 2 per cent in early 2017, reflecting higher oil and tobacco prices. Headline inflation is then expected to be 2–3 per cent by the end of the forecast period.”

The key to this outlook for inflation is that the pick up in growth is expected to reduce the level of excess capacity in the labour market. This in turn is expected to feed into rises in labour costs which will ultimately underpin the steady increase in underlying inflation over the forecast period, resulting in it returning to the target band.

The question is, if there is no change in the forecasts for growth and inflation, what does that mean for the outlook for the cash rate?

Outlook for Interest Rates

The more important question, rather than what the RBA’s forecasts mean for the outlook for the cash rate, is what the outlook for the cash rate means for the forecasts. This is an important differentiation as the expectations, or market pricing rather, for the cash rate is one of the key assumptions that feed into the RBA’s forecasts.

Under the RBA’s assumptions, the cash rate is expected to move broadly in line with market pricing. At the time the forecasts were put together, the market wasn’t pricing in any change to the cash rate for the time being. That means growth is expected to pick up to 3% then accelerate in the longer term, taking inflation back into the target band over time with the cash rate remaining at 1.50%. As we are constantly reminded by the RBA, there are always risks to forecasts.

The upside risk is the global economy continues to pick up, boosting domestic growth with it. This would result in growth accelerating a little earlier than forecast, taking inflation with it. Under this situation, the RBA could easily tap the brakes as required by lifting the cash rate. With the substantial increase in the level of debt while rates have been in decline, it wouldn’t take much for the RBA to slow things down were the economy and inflation really starting to heat up.

The downside risk is that growth doesn’t bounce back in the near term as expected. We can see from previous forecasts, that growth has repeatedly undershot forecasts for some time. More importantly there is little wiggle room to move for the RBA under this scenario. Any miss from growth over the near term is likely to impact the outlook for inflation, which is already as weak as it can be without forcing the RBA to act. Any downgrade to the outlook for inflation could tip the RBA’s hand.

It won’t be long until we see how growth is tracking compared to the RBA’s forecasts. Barring any revisions to the data, the economy will need to bounce back from its 0.5% decline in Q3 and grow by 0.9% to hits the RBA’s year end forecasts. If the economy managed to do just that and maintain momentum then the RBA’s forecasts of 3% growth will be attainable by year end. Any more than a minor miss from growth over the next six months could leave the RBA between a rock and a hard place.

Australian Economic Highlights

  • Growth disappointed across the board in Q3 with GDP falling by 0.5% for the quarter. The sharp fall which saw most components of growth fall, saw the annual rate decline significantly from 3.1% to 1.8%, well below the RBA’s forecasts.
  • CPI was soft again in Q4. Headline inflation was up 0.5%, short of the 0.7% rise that was expected. The quarterly increase was still enough to lift the annual rate from 1.3% to 1.5%. The RBA’s preferred measure, core inflation, just missed expectations, rising by 0.4% which saw the annual remain largely unchanged at 1.5%.
  • The employment data finished off this year with a steady gain of 13,500 jobs. Full time employment rose by 9,300 whilst part time employment was up 4,200. The unemployment rate edged higher once again to 5.8% as the participation rate continued to rise, hitting 64.7%.
  • ANZ job ads bounced back in January after a disappointing end to the year, positing a gain of 4.0%, more than offsetting the revised 2.2% decline in December.
  • NAB business conditions built on Decembers improvement, jumping from 10 to 16 in January a multi year high thanks to broad bases gains across all sectors. Business confidence also improved after tracking sideways of late with a rise in the index from 6 to 10.
  • Consumer confidence printed below the key 100 level for the second straight month in December as consumers remain cautious on their own finances, especially compared to a year ago even after two rate cuts last year.
  • The rebound in Retail sales finished the year with an unexpected decline, falling 0.1% leaving total sales unchanged for the last two months of the year. Despite the weakness in the quarter which saw sales grow by 0.45%, sales ex-inflation for the quarter were up 0.9%, confirming the significant price pressure weakness in retail at present.
  • Housing finance a little more subdued in December after a bumper increase in November. The number of owner-occupier loans were up 0.4% with the value of occupier loans also up 1.3% while investor lending fell 1.0% after a huge 5% gain the previous month.
  • Australia posted its biggest ever trade surplus in December at $3.5bln, adding to the revised surplus of $2bln the previous month. Despite the huge turnaround in the trade balance in Q4, it is not expected to add much to real GDP over the quarter.
  • After bouncing back in November Building approvals continued their slide in December, posting a fall of 1.2%. The December reading has resulted in the annual rate of building approvals falling 11.4% from a year ago suggesting the peak in the construction cycle is behind us.
  • Motor vehicle sales posted a small gain in December after two straight months of declines.  The 0.3% gain in December was enough to lift the change into the black with a small increase of 0.2%.
David Flanagan

David Flanagan

Director: Interest Rate Markets