At least two more 25bps cash rate cuts are likely to be needed in the current rate cutting cycle in our view and it is also becoming increasingly clear that very low interest rates may persist through 2016 and possibly in to 2017. The reasons we have become convinced that rates will stay lower for longer relate to the softening global economic growth outlook, the persistence of very low inflation and several headwinds to Australian economic growth developing through 2016.
We now see the RBA cutting the cash rate by 25bps to 1.75% at its next policy meeting on November 3rd and following up quickly with another 25bps cut to 1.50% either in December or in February 2016.
Taking the international economic outlook first, the economic data from several key countries and regions has come in mostly softer than expected in August and September. Even those countries previously expected to be starting to consider lifting official interest rates, such as the United States and the United Kingdom, have received readings soft enough to stop their rate hike plans. In the US, September retail sales, -0.3% excluding automobile sales, after a revised -0.1% in August and September industrial production, down by 0.2% after falling 0.1% in August both point to soft US economic growth in Q3 2015. The Federal Reserve’s own economic reports from its 12 district offices, the “Beige Book”, also took a noticeably weaker turn in the October report with only three districts reporting moderate economic growth; six modest activity; two slowing activity; and one district in contraction. Inflation remains all but non-existent in the US with producer prices down 0.5% in September and -1.1% y-o-y and the September CPI recording -0.2% in the month reducing annual inflation to 0.0% y-o-y.
In the United Kingdom it has also been the surprising lack of inflation pressure that is causing the Bank of England to delay lifting interest rates. In Asia the volume of exports for the entire continent is falling adding to downward pressure on growth. In Europe faltering progress on a number of fronts has started to fade too. August retail sales were flat, industrial production fell by 0.5% and the unemployment rate stalled at 10.9%. Europe also slipped back in to slight price deflation (-0.1% y-o-y) in September. The European Central Bank has said that it has flexibility to extend unconventional monetary policy easing. It may have to deliver before long.
Set against this apparent shift towards softer growth internationally Australian monetary conditions appear to have tightened over the past month or so, and against the stated policy intention of the RBA to maintain a growth accommodating policy setting. Part of the tightening in monetary conditions has come from the firming Australian dollar since early September, up around 4% against the US dollar and also on trade weighted basis. Then last week came the announcement from Westpac that it plans to lift the variable interest rate it charges on all categories of home loans by 20bps.
The Westpac home loan interest rate increase is part of its response to meeting prudential changes to capital adequacy. More likely than not, other lenders facing similar capital adequacy changes may choose to lift home loan interest rates too. Whatever happens, the RBA has a policy dilemma on its hands. The major banks preparing for capital adequacy changes is desirable from the point of view of prudential policy but it may come at the cost of adding to forces that promote a disorderly decline in housing activity.
A number of factors are coming together to form something of a perfect storm for housing in Sydney and Melbourne. Sharply rising house prices over the past two years have boosted substantially the numbers of homes for sale. The number of new homes approved and in the early stages of construction are racing ahead of growth in the prime home buying age group. Housing investors are being constrained by limits on lending growth in Australia as well as more stringent application of foreign investment guidelines and increasing restriction on sending funds out their own countries.
At best it seems that house prices will decline around 5-10% over the next year and that by the second half of 2016 new home building activity will be falling. There is a risk that the outcome could be worse.
One of the key drivers of Australian economic growth over the past year and still continuing perhaps through early 2016 is likely to start detracting from economic growth later in 2016 and in 2017. The mining investment downturn still has some way to run with more job losses coming in the sector. The planned run down of automobile manufacturing in Australia will also be generating job losses in 2016 and 2017. There are positive offsets. Perhaps the most noticeable one is inbound tourism, while personal services in all forms continue to grow strongly.
On balance, though, Australian annual GDP growth barely managing 2.0% y-o-y at present is likely to be even weaker in 2016. While a recession is not imminent it is possible at some stage next year. In these circumstances, the effective tightening of monetary conditions since early September threatens to make economic conditions worse than they need to be. We see the RBA recognising more fully the downside risk to Australia’s growth prospects and responding by cutting the cash rate twice over coming months to ensure that monetary policy is as growth accommodating as it intends it to be.