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The economic tide is on the turn, but not the way the official family (Treasury and RBA) is expecting. The official view is that the dominant force influencing Australian economic prospects over the next year or two is the downturn in mining investment spending keeping the economy growing below long-term trend for a protracted period. However, a big, positive force on economic growth, rising household spending, is starting to show and if households start to cut in to their savings, built up in a prolonged bout of acute risk aversion since the global financial crisis, growth in household spending could easily accelerate and considerably overwhelm the impact of falling mining investment on growth prospects. If, as we think is likely, annual economic growth accelerates to 3.5% in 2014, rather than languishes around 2.5% as the official family is forecasting, the outlook for interest rates is impacted materially.
On the official family’s growth and inflation views, the cash rate is likely to stay at 2.50% through 2014, with a bias towards a lower cash rate. On our view of stronger economic growth, the RBA will spend the first half of 2014 revising up its economic growth outlook and by mid-year is likely to start warning of potentially higher inflation in 2015. It is likely to follow the warning in Q3 2014 with the first of a series of cash rate hikes – a series of hikes because one cash rate lift is never sufficient to dampen expectations sufficiently when the inflation outlook turns less benign.
We are tentatively building in to our forecasts a first 25bp cash rate hike in August after the release of the Q2 CPI report in late July, the likely point when the RBA would revise up its inflation forecasts. Another 25bp cash rate hike would likely follow in September and third hike taking the cash rate to 3.25% would probably come at the Melbourne Cup Day RBA policy meeting in November, after the Q3 CPI release in late October.
Economic forecasting is always a tricky business, but we see evidence accumulating that economic growth is on the cusp of a stronger turn. Home buying activity improved strongly throughout 2013 feeding strong growth in house prices and finally a very strong run of monthly home building approvals numbers in late 2013. November marked a record third consecutive month of 16,000+ home building approvals taking total home building approvals up 22.2% compared with November 2012. It is reasonable to say with a considerable degree of confidence that home building work in progress plus the jobs in housing construction that run with it will be running at the strongest pace in many years in 2014.
Even the strongest of improvements in housing battles to make much difference to the overall economic growth outlook because housing is a lightweight in terms of spending contribution to GDP, accounting for only 4.6% of GDP in Q3 2013. Business investment spending makes a much bigger contribution to GDP, 8.9% from non-dwelling construction plus 5.0% from spending on plant and equipment. If business investment spending falls by 5%, a possibility as mining investment retrenches, housing would need to lift by 15% just to offset and that leaves growth flat-lining.
The part of GDP that can make a huge difference is household spending, accounting for 53.3% of GDP in Q3 2013. The impact of a 5% fall in business investment spending can be offset by just a 1.3% lift in household spending. Interestingly, household spending is shaping up for a lift of at least this size in Q4 2013. So far, retail sales data are available for October, up 0.5% in the month, and November, up 0.7%. All indications are that retail sales rose even more strongly in December, implying that retail sales may have increased by more than 2% in the quarter, at least 1.5% after allowing for inflation. Household consumption spending growth alone may have been more than enough to offset the most pessimistic estimates of likely decline in business investment spending. In addition improving housing activity and net exports also probably made good, positive contributions to GDP growth in Q4 2013.
In our view, the Q4 GDP report due on 5th March is likely to be materially stronger than the Q3 GDP report and may be the catalyst for upgrades to the official family’s 2014 growth forecasts. Importantly, the main driver of stronger Q4 GDP growth, a sharp lift in household consumption spending, is no flash in the pan, but rather the result of the household sector becoming less risk averse and starting to become more confident about dipping in to savings to spend, both directly and also by borrowing more freely.
Household savings as a proportion of household disposable income jumped sharply from 4% to 12% in 2008, the year of the global financial crisis as households took fright and has hovered in 10-12% range since (it was 11.1% in Q3). Every percentage point fall in the household savings ratio potentially lifts household consumption by more than one percentage point. If households are finally getting over the impact of the global financial crisis and are regaining confidence to tuck less away in precautionary savings, as we think is likely, household consumption and ultimately growth will be much stronger in 2014 than is widely believed likely at present.