A discussion by RBA Board members of research by the RBA concerning Australia’s neutral real cash rate (a cash rate consistent with steady economic growth around the potential growth rate and annual inflation steady around 2.5%) reported in the minutes of the 4th July Board meeting caused a brief stir in local financial markets last week. Essentially the research indicated that the real neutral cash had fallen from around 2.50% in 2007 to about 1.00% currently for various reasons and after adding 2.5% for mid-target range inflation takes the neutral nominal cash rate to 3.50% against the current cash rate of 1.50%. The present real cash rate well below zero is very expansionary and has been for the past five years. The RBA Board’s discussion of the neutral cash rate at the last policy meeting was essentially an academic exercise and is not a forecast or even a hint of near-term monetary policy change. It is, however, a reminder that the current cash rate is abnormally low – fine if the economy still needs a bit of pep from low interest rates and inflation is contained, but in need of adjustment if growth and inflation are threatening to lean on the softer or stronger side.
The RBA’s own forecasts of growth and inflation last published in its early May quarterly Monetary Policy Statement showed annual real GDP growth accelerating to 2.75% to 3.75% range (above potential growth) in June 2018 and annual inflation lifting to 2% to 3% range by mid-2019. If these growth and inflation forecasts are realised the cash rate would need to be nearer to the neutral 3.50% by mid-2019. Factors such as the relative strength of the Australian dollar may make a difference, but even assuming further strength in the Australian dollar it is unlikely that the cash rate should be any lower than say 2.50% if the RBA’s economic forecasts come to fruition.
Of course, the chances of the RBA’s economic forecasts coming to fruition is a big if and it is probably fair to say that most analysts have until recently foreseen rather weaker growth and inflation this year and next on factors ranging from a potential dip in China’s growth rate to local potential brakes on growth from high household debt; housing downturn; and persistently low wages growth. The RBA has been characterized disparagingly as a “glass more than half full” forecaster. Interestingly, recent data releases from Australia’s major international trading partners and local data releases seem to have increased the likelihood that the RBA’s economic forecasts are on the right track and may even need to be tweaked a touch firmer.
Among the data releases pointing to firmer Australian economic growth and perhaps higher inflation down the track are better-than -expected GDP growth in China, 6.9% y-o-y again in Q2 and with June readings of urban fixed asset investment spending and industrial production – both key influences on Australian mineral export growth – stronger-than-expected too, up respectively 8.6% y-o-y and 7.6% y-o-y. These relatively strong readings may settle lower but so far, they continue to confound on the stronger side of expectations.
Locally, the household sector seems to be coping with record high debt and very low wages growth and is showing signs unexpectedly of starting to spend more freely. Retail spending lifted noticeably in April (+1.0% m-o-m) and May (+0.6%) compared with average monthly increases of only +0.1% through Q1 2017 and Q4 2016. Part of the reason why households may be starting to spend more freely is that labour market conditions have been firming for some months with consistently good monthly gains in employment, a modest fall in the unemployment rate to a 4-year low and strong growth in job vacancies implying more employment gains to come. There are also the first signs that annual wages growth languishing at a record low 1.9% y-o-y in Q1 and Q2 2017 may soon start to lift a little. The recent Federal Minimum Wage determination granting a 3.3% increase to the minimum wage will contribute and may become a benchmark for broader wage negotiations in the stronger employment market.
As we mentioned last week the Q2 CPI report due on Wednesday will have an important influence on any adjustment that the RBA may make to its inflation forecasts due to be published in its next quarterly Monetary Policy Statement in early August. A Q2 CPI outcome around market consensus forecast of +0.4% q-o-q, +2.2% y-o-y (RBA forecast 2.0% y-o-y) would probably leave the RBA with just enough wriggle room to not raise its inflation forecasts. Any upside CPI surprise, especially if corroborated by higher than expected underlying inflation readings (consensus forecasts +0.5% q-o-q for both the trimmed mean and weighted median) would place pressure on the RBA to lift its inflation forecasts bringing forward the period when it may need to achieve a “neutral” cash rate setting from mid-2019 to late or mid-2018. In contrast, a downside inflation surprise on Wednesday may provide more room to keep its low and well-contained inflation outlook in turn leaving more room to leave the cash rate unchanged for longer.
We need to wait for Wednesday to see exactly where the Q2 CPI and underlying inflation readings come in. Perhaps what is important to realise is that there are more signs starting to show that the low-growth, low-inflation nexus that has allowed the RBA to sustain the very low 1.50% cash rate could take a stronger turn. The RBA’s work on the neutral cash rate implies that if these stronger growth and inflation signs continue to show over coming months they will hike the cash rate and probably three or four times at least over the next 18 months or so. We now see the first of those rate hikes occurring at latest in Q1 2018.