The interest rate outlook is turning more difficult to call. The RBA’s quarterly Monetary Policy Statement released last Friday highlights several areas of uncertainty relating to the global and local economic outlook. On balance, however, the RBA is relatively upbeat in its economic forecasts expecting continuing above trend economic growth in the US and euro-area economies; Australia’s major trading partners to grow much as they did in 2015; and in Australia the rebalancing away from non-mining resource activity to continue permitting moderate, albeit still sub-trend, GDP growth to continue with further reduction in the unemployment rate. The RBA expects inflation to stay low providing scope for easier monetary policy, “should that be appropriate to lend support to demand”.
The bottom line for the monetary policy outlook seems to be a protracted period with the cash rate stable at 2.00%, although with a possibility of a lower cash rate if the rebalancing of activity away from resources sector activity turns out not to be strong enough to sustain sufficient aggregate spending in the economy. The key to unlock sufficient aggregate spending is that employment continues to grow and the unemployment rate continues to fall much as it did through 2015.
One big problem is that although the RBA expects the unemployment rate to fall further, much as occurred in 2015, because the reduction in 2015 was difficult to explain, there is an unusually high element of uncertainty surrounding whether the improvement is sustainable.
It is very unusual for an economy growing sub-trend and with particularly soft growth in domestic spending to generate strong employment growth as occurred in Australia through 2015. One possible explanation is that the pattern of economic activity is changing with much greater emphasis on spending on personal services and less emphasis on spending on goods. This explanation fits with key drivers of employment growth in 2015. Most goods producing parts of the economy lost employment in the year, but services areas of the economy increased employment and in some cases spectacularly – health care and social services added more than 150,000 jobs, nearly half the lift in total employment in the year.
While the story of lifting employment in services seems a valid one there is still an issue whether the front-runner in the employment gain stakes by a substantial margin, the health care and social services sector, can possibly put on another 150,000, or 10% y-o-y, workers in 2016. While there is no doubt that Australia is ageing and arguably becoming less healthy, back-to-back huge annual employment increases in the sector would seem to speak of an improbable explosion of ageing and sickness in the community.
In short, even if the greater employment in services thesis holds as a reasonable explanation of strong total employment growth to date, there seem to be some anomalies in the data that are likely to iron out in 2016 pointing to high risk of a phase of softer growth in total employment and a stable, or even rising unemployment rate.
What is clear is that the RBA will take a keen interest in developments in the labour market and that it may take several months to either clarify its current economic forecasts or point to them being perhaps too optimistic.
Apart from local labour market developments, the RBA will also be keeping a weather watch on overseas economic developments – unforeseen weakness in global economic activity could become a cause to cut local interest rates – as well as developments in the Australian housing market and perhaps developments in local lending interest rates too.
The RBA sees housing activity as being better balanced between owner-occupier buying and somewhat curtailed investor demand. The RBA also sees continuing overseas demand for Australian housing. A better-balanced housing market is an important part of sustaining reasonable growth in domestic spending. Should better-balanced demand turn to much softer demand that might also prompt the RBA to cut its cash interest rate.
Another factor that may be important for the RBA is how local lenders react to the continuing stability in the cash rate. As local lenders continue to adjust to longer term changes in capital adequacy requirements there is always the risk that they may again ask their depositors and borrowing clients to share part of the cost. Lending interest rates may rise without any change in the RBA’s cash rate. If they do, there could be pressure on the RBA to try and offset an unwanted de facto tightening of monetary policy.
So there are many factors influencing the RBA’s rate decisions going forward and all are hard to call. The base case is that the cash rate stays unchanged at 2.00% for some time. The risks to the base case are substantial and skew almost entirely towards economic weakness and the possibility of a lower cash rate. That is why we still see a high probability that the cash rate will need to be cut further at some stage in 2016 and that it will likely be a two-stage step down to 1.50%.