–  JUNE 2019 INSIGHTS BY THE CURVE TEAM –

Highlights

  • After leaving the cash rate on hold for 33 straight months, the RBA lowered the cash rate to 1.25% at their June meeting.
  • Governor Lowe stressed that the decision was not driven by a deterioration in the outlook but rather a revision to their assessment of what constitutes full employment.
  • The data, especially employment data, remains the key to the outlook for monetary policy.
  • However the RBA stressed that monetary policy cannot do it alone and has called for other policy makers to play their role.

Rates Recap

  • After leaving the cash rate on hold for 33 months, they decided to lower the cash rate by 25bp at its June meeting to a new low of 1.25%.
  • The post meeting statement gave little away with Governor Lowe stressing at a speech later that night that the decision wasn’t driven by a deterioration in the outlook.
  • Instead, the RBA’s decision was driven by a revision to its assessment of full employment, or NAIRU, which is now considered to be four point something while previously it was thought to be around 5%.
  • He also reaffirmed that the assumptions underpinning the forecasts were that the cash rate moves in line with market pricing which points to at least one more rate cut.
  • The move by the RBA has seen the yield curve continue to flatten. The government bond curve has actually inverted with the 1 year yield now higher than the 5 year.
  • While the RBA may cut rates further, we could have seen the long end of the curve reach its low point already.

RBA Flags More Cuts, Urges Policy Makers Help Share The Burden

After flagging the RBA would “consider the case for lower rates” at their June board meeting in his speech on the 21st of May, Governor Lowe and the Board cut the cash rate to 1.25% at their June meeting. It is the first time the cash rate has been changed in almost 3 years and it was also Governor Lowe’s first adjustment of the cash rate.

The accompanying statement to the decision to lower the cash rate gave very little insight into the reasons behind the Board’s decision nor did it give much of an insight on the outlook for policy going forward. Instead, Governor Lowe waited until his address at the Reserve Bank Board Dinner later that night to outline the reasons behind the decision and the implications for the outlook for monetary policy.

In justifying the decision to lower the cash rate, Governor Lowe said that “at its core, today’s decision was taken to support employment growth and to provide greater confidence that inflation will be consistent with the medium-term target.”  To further understand the driver behind the decision, it is worth recapping what the RBA’s mandate actually is:

Its duty is to contribute to the stability of the currency, full employment, and the economic prosperity and welfare of the Australian people.

Governor Lowe stressed that “the decision is not in response to a deterioration in our economic outlook since the previous update was published in early May.” Instead it was recognition, based on “the accumulation of evidence” that there is more spare capacity in the labour force than previously thought.

This conclusion was based on a combination of two main data points. The first was continued evidence of weak inflation pressures permeating throughout the economy. The second was the recognition that the ongoing strength in the labour force was not making material inroads into the current level of spare capacity.

As a result, the RBA has recalibrated their perception of full employment with Governor Lowe saying that:

“For some years, most estimates of full employment, including our own, equated to an unemployment rate of around 5 per cent – it was thought that if unemployment went below that for too long, inflation would rise and become a problem. But, given the combination of the labour market and inflation outcomes we have seen of late, our judgement now is that we can do better than this – that we can sustain an unemployment rate of 4 point something.”

It is somewhat surprising that it took the RBA so long to come to this conclusion. It has been clearly evident, from a number of jurisdictions around the world from the US, the UK and Japan, that levels previously considered as full employment or NAIRU (non-accelerating inflation rate of unemployment) have fallen considerably.

The US and UK have unemployment rates below 4% and Japan has an unemployment rate below 3% and none of these countries have seen any material uplift in inflationary pressures.

Aside from the common experience seen overseas, one area that caught the RBA by surprise was the supply side of the labour force. Governor Lowe admitted as much by saying that “the participation rate is currently at a record high, despite demographic shifts that we anticipated would reduce participation.” This also contributed to the accumulated evidence that there was more slack in the labour force than previously expected.

The big question now is, what till it take to to get the unemployment rate to a level that will make inroads into spare capacity in the labour force, boost wages and in turn help lift the inflation rate back towards the target band?

Outlook for Interest Rates

In his speech at the dinner following the RBA’s decision to cut the cash rate, Governor Lowe gave some clear insights into the outlook for monetary policy over the near term. What was of more concern were his comments around the long term outlook as monetary policy enters uncharted territory.

When answering his own question “are interest rates going to be reduced further?”, the Governor said that:

“The answer here is that the Board has not yet made a decision, but it is not unreasonable to expect a lower cash rate. Our latest set of forecasts were prepared on the assumption that the cash rate would follow the path implied by market pricing, which was for the cash rate to be around 1 per cent by the end of the year.”

The decision to lower the cash rate to 1% and when it occurs will be driven by how the data, in particular employment outcomes, evolve over the months ahead. Given the RBA broke with its own protocol of only easing in a month that was accompanied by their quarterly Statement on Monetary Policy, every meeting should now be considered live.

Market pricing currently suggests that the next move is likely to come in August. This will give the RBA two more updates on the employment market as well as the latest inflation data for the second quarter. It will also give them the opportunity to flesh out their reasons for the decision and update their forecasts in the August quarterly Statement on Monetary Policy due the Friday after the meeting.

However Governor Lowe seems to do things his own way so a July move or even a longer pause with a move later in the year can’t be ruled out either.

When looking beyond the near term outlook for monetary policy, Governor Lowe posed the questions that

“If you accept the argument that a sustainably lower rate of unemployment in Australia is achievable, the question that we should all be thinking about is: how do we get there?”

While monetary policy has a role to play and the RBA has the capacity to do more, Lowe wanted to acknowledge that “monetary policy is not the only option.” Like he did in his speech back in May, he highlighted that the Government needs to do more to help. Fiscal policy, much like monetary policy, can help over the short term, providing a boost to kick start growth.

The Governor then essentially called on policy markers to do their part, saying that:

“From my perspective, the best option is the third one – structural policies that support firms expanding, investing, innovating and employing people. A strong dynamic business sector is the best way of creating jobs. Structural policies not only help with job creation, but they can also help drive the productivity growth that is the main source of improvement in our living standards.”

So given that “there are certain downsides from relying just on monetary policy and there are limitations on what, realistically, can be achieved”, it is up to policy makers to do their bit to support growth over the longer term.

It also means that in the absence of an increase in fiscal support and longer term policy reform, downside risks to monetary policy will remain in place as the RBA pursues its mandate of full employment. That is why the market is entertaining the idea of a move in the cash rate below 1% with a third interest rate cut nearly fully priced in for late 2020.

Australian Economic Highlights

  • Growth fell short of estimates again in Q1 with the economy only growing by 0.4% as the weakness from the second half of 2018 spilled into the start of 2019. The annual pace of growth slowed further from 2.4% to 1.8% and is likely to undershoot the RBA’s estimate this quarter.  
  • Inflation came in well below expectations in Q1 with headline CPI flat for the quarter which saw the annual rate fall from 1.8% to 1.3%. The RBA has moved to using the trimmed mean as their preferred measure of core inflation and it increased by 0.3% for the quarter with the annual rate slipping from 1.8% to 1.6%
  • The employment data saw another month of solid jobs growth with 28,400 new jobs added. However this month was skewed towards part time jobs. Despite the solid growth, the unemployment rate jumped to 5.2% on another increase in the participation rate. 
  • The ANZ job ads completely collapsed in May, falling 8.4%, the biggest monthly fall since the GFC. The fall does look like an anomaly and could be associated with the timing of the election. Next month’s data should give a better gauge of the ongoing trend.  
  • Business confidence appears to have received a much needed boost following the election with the index jumping from 0 to 7. The survey period straddled the election weekend so it is still too early to assess the full impact of the result. Business conditions continued their recent trend with a further deterioration in May, taking the index from 3 to 1. Trading conditions fell heavily while profitability fell below 0 for the first time since the corresponding month 5 years ago. 
  • Consumer confidence continues to gyrate around the inflection point that separates pessimists and optimists. The index remained fairly stable post election with a 0.6% rise to 101.4.
  • After lacklustre first quarter, Retail sales started the second quarter off poorly.  Total sales were down 0.1% for April and would have been worse were it not boosted by food sales. There is growing signs that even with confidence holding up ok, households are limited discretionary spending as wage growth remains weak and house prices continue to fall. 
  • Housing finance remains under pressure, with investors still leading the declines in new approvals. The value of investor finance was down a further 2.2% in April which was somewhat offset by a 1% rise in the value of owner occupier approvals. Interestingly, despite the rise in the value of loans, the number of owner occupier approvals was down 1.1%.
  • Australia’s trade surplus continued to hover around the $5bln mark in April. However the latest result was more positive with a solid rise in both exports and imports over the month, with almost all import sectors rising over the month.
  • Follow the volatility the previous two months, the downtrend in Building approvals resumed in April. Total approvals were down 4.7% taking the annual decline to 24.2%. Total building approvals are now down almost 40% from their late 2017 peak.
David Flanagan

David Flanagan

Director Interest Rate Markets