The Reserve Bank (RBA) left the cash rate at 2.50% at its board meeting last week, a decision that was very widely expected. The statement accompanying the decision was brief, but was notable for removing a key sentence from statements after earlier policy meetings that made it clear that the RBA, because of the low inflation outlook still had the capacity to lower the cash rate further if needed. In effect, the RBA was expressing a bias towards easing policy further at earlier meetings and that bias has now changed to neutral. As the RBA explains in the latest statement, interest rate sensitive parts of the economy, such as home loan applications and asset prices are showing signs of improvement and on their reckoning more improvement is likely. The RBA is saying that current interest rate settings are appropriate even for an economy growing below trend and with an unemployment rate drifting higher.
Our take is that the RBA’s change to a neutral policy bias is clear cut. We believe the RBA wants to take several months before it makes its next interest rate move as it monitors developments in the global economy that on balance have taken a more positive turn over the past month or two, and whether the Australian economy is rebalancing – how well spending is improving outside the mining sector to compensate for falling mining investment spending. One factor that may have added to restraints on business and consumer spending may have been the long run up to the federal election at the weekend. The RBA will want to assess the extent of any positive sentiment shift after the election and how that adds to the impact of very low interest rates.
If our economic view at Laminar is correct, it will not be long before the accumulation of more positive economic readings in the US, Europe and China lead to upward revision of market views about global economic growth in 2013 and 2014. Several analysts have lifted their European growth forecasts over the past month and the process appears to have started for China too with the better economic readings of late. View changes about the US economic growth outlook may take a little longer to develop because US economic improvement has progressed to the point where the US Federal Reserve (Fed) looks set to taper very cautiously its monthly $US85bn bond buying, non-interest rate, or unconventional monetary policy easing (QE) program. The market has been well primed for this move by Fed comments since mid-May and arguably has reacted as much as it will in terms of driving up government bond yields and long-term home mortgage rates. If this proves to be the case, US economic numbers should continue to improve on balance through September and October, but with less market concern that improving growth will be set back by higher yields.
We see two reasons why the lift in US longer-term interest rates should be relatively well contained through the QE tapering process. The first is that with inflation still very low, the Fed is primarily sensitive to risks to the economic recovery and is unlikely to risk any action that pushes up longer-term interest rates too far. The second is that conventional monetary policy tightening i.e. starting to lift the near-zero funds rate, is still a very long way down the track, possibly 2015 at earliest. Short-term interest rates are likely to be anchored near zero throughout the QE tapering process and well beyond. The US economy continues to show signs of better growth even after the back-up in longer term interest rates.
Returning to Australia, an improving global growth outlook, particularly one that includes upward adjustment to China’s growth prospects implies that the RBA will eventually come out of the current interest rate pause period by opting to unwind a part of its current very accommodating policy stance. When monetary policy starts to unwind (our current estimate is not before Q2 2014 and that could easily drift later) it is likely to be a cautious process and is likely, in our view, to involve only limited hikes in total.
Part of the reason for our extended relatively low interest rate outlook is that Australian wages growth and inflation look comparatively well contained for the foreseeable future. A second reason is that Australian GDP growth, even in the approaching acceleration, is very different from what it was a few years ago. In the four financial years leading up to and at the beginning of the global financial crisis (2005-06 through to and including 2008-09) real annual GDP growth averaged 3.1%, but that is only one part of the story. Prices for Australian exports were rising fast through the period and as a result, annual GDP growth measured in current prices averaged 8.0% through the period, extraordinarily rapid growth and it is this latter growth measure that helped generate strongly rising tax revenues, big government budget surpluses and the wherewithal for annual income tax cuts and a general feeling of well-being for households and businesses.
Since 2008-09 annual real GDP growth has averaged 2.7%, below long-term trend around 3.0%. More importantly current price GDP growth has decelerated sharply to 4.8% and on latest GDP measures for Q2 2013 annual real GDP growth was 2.6% while current price GDP growth was 3.0%. Relatively low current price GDP growth is unlikely to improve much in the foreseeable future placing a formidable constraint on growth in government tax revenues. The Government, whatever it may wish to do with its budget, is likely to be poorly placed to provide any net tax cuts because of persistently low growth in current price GDP. Households and businesses may pick up some confidence in the wake of the election, but there are still headwinds that imply that spending will not accelerate as fast as it would have a decade ago. The corollary of a more cautious pick up in domestic spending is that that the RBA will be able to exercise a much lighter touch on the monetary policy brake when it needs to use it this time around. The top of the next cash rate cycle may well be below 4.00%.