We would normally be writing an end-of-month Economic Roundup, but RBA Governor Philip Lowes’s speech on the economic outlook presented in Brisbane last week made it clear that the RBA will consider cutting the cash rate at its next policy meeting in early June. Clearly our long-held view that the cash rate will stay at 1.50% well in to 2020 is wrong and we need to change it. Our revised view is that the RBA will cut the cash rate twice, by 25bps to 1.25% in June, and by a further 25bps to 1.00% in August. The cash rate will probably stay at 1.00% for a year or so ahead of a modest hiking cycle starting in 2021.
Essentially, the RBA believes that the great conundrum in the Australian economy – the coexistence of soft real GDP with a strong labour market – will resolve in the near-term not with improving real GDP growth but with softening labour market conditions. The RBA backs up its view of real GDP growth struggling to improve with evidence of longstanding weakness in annual growth in household disposable income ( less than 3% y-o-y in recent years against an average nearer to 6% y-o-y previously) and growing belief in Australian households that weak income growth is becoming permanent. In turn real growth in household consumption spending has suffered and without assistance is unlikely to improve in the near term.
There are improving parts of the Australian economy – exports; government infrastructure spending; and business investment spending – but they are unlikely to counterbalance the impact of soft growth in household consumption spending and housing sector weakness.
Importantly, the RBA believes that the labour market has stopped improving and there is risk that the unemployment rate will edge higher. At its best the national unemployment rate touched down just below 5% earlier this year. In the past an unemployment rate of 5% or lower would have been consistent with increasing labour shortages, rising wages and upward pressure on inflation. This time there has been only limited evidence of labour shortages, wages growth has remained low and slow and the annual inflation rate has fallen to 1.3% y-o-y in the case of the CPI in Q2 2019 and around 1.6% y-o-y for the various measures of underlying inflation.
With the unemployment rate starting to edge upwards to 5.2% in April wages growth and inflation are threatening stay low for longer. Also, the RBA is considering the idea that the unemployment rate consistent with higher wage and inflation (inflation returning inside its 2-3% target band) is no longer around 5% but possibly 4.5% or lower. The RBA could use monetary policy to help achieve an unemployment rate below 5% that would help to lift real GDP growth and return inflation inside its target band.
Returning to the concluding words in RBA Governor Philip Lowes’s recent speech,
“Earlier today we released the minutes of the Board’s meeting two weeks ago. At that meeting we discussed a scenario in which there was no further improvement in the labour market and the unemployment rate remained around the 5% mark. In this scenario, we judged that inflation was likely to remain low relative to the target and that a decrease in the cash rate would likely be appropriate. A lower cash rate would support employment growth and bring forward the time when inflation is consistent with the target. Given this assessment, at our meeting in two weeks’ time, we will consider the case for lower interest rates”.
The approaching interest rate cuts are likely to form part of what is shaping up as a super-sized policy boost to Australian economic growth. APRA has announced that it is reducing the mortgage interest rate test that banks need to apply to potential borrowers that will allow loan sizes to increase. The approaching increase announced by the Government in the low- and- middle- income tax rebate will soon boost growth in household disposable income and probably consumer spending too.
Lower home mortgage rates and less constraint on how much can be borrowed mean that it is reasonable to expect noticeably stronger demand for housing over coming months and an end to declining house prices in Melbourne and Sydney by the end of the year. Excess supply of new homes means that home building activity will take longer to improve, perhaps in the second half of 2020. Real household consumption spending growth is likely to look firmer in the second half of 2019, assisted by lower tax boosting household disposable income.
By late 2019/ early 2020 the already strong parts of the economy (exports; government infrastructure spending; and increasingly business investment) are likely to start receiving reinforcement from previously weak housing and household consumption spending leading to renewed reduction in the unemployment rate through 2020. By mid-2020 prospects for wages growth and inflation should look higher than they do currently causing the RBA to consider when it should reverse the two cash rate cuts delivered in 2019.
At this stage, after penciling in two 25bps cash rate cuts in June and August, we expect the unemployment rate will fall to 4.5% at some point beyond mid-2020 and to be the trigger for the RBA to take back the two 2019 rate cuts. In short, the 1.00% cash rate from August should last around 18 months but will eventually result in the cash rate returning to 1.50% in 2021.