Australian & New Zealand Weekly

Week beginning 18 August 2008

• Reserve Bank Board Minutes to indicate the degree of urgency of rate cuts.
• Australian data: Westpac-MI Leading Index, imports, car sales.
• NZ data: external migration and producer price data due.
• US Fed Chairman Bernanke to speak on financial stability at annual Jackson Hole symposium.
• US data focus: PPI, housing starts and permits, Philly Fed index.
• UK focus on August Bank of England meeting minutes.
• Key economic & financial forecasts.

Australia: Reserve Bank Board Minutes to Indicate the Degree of Urgency of Rate Cuts

Next week we will see the RBA's Minutes of the August 5 Board Meeting. We will be looking for clues with regard to the likely result of the upcoming September 2 Board meeting. Markets and most commentators are resigned to the RBA delivering a rate cut at the September meeting and we strongly concur. The two key issues now are, for the short term, whether we see a 50bp cut on September 2 and the overall profile of the rate cut cycle.

Last week markets assessed the probability of a 50bp cut at around 50%. That was cut to 25% mainly because the wording of the Statement on Monetary Policy did not indicate any real 'urgency'. Today that has moved back out to 50%.

As with the Statement by the Governor following the Board meeting the language in the body of the Report was reasonably mild. Indeed the section on forecasts talked of a modest reduction in growth forecasts from the May Statement.

Recall, however, that the RBA's growth forecast in May was substantially lower than market expectations so to further lower forecasts represents a considerable reduction in growth outlook from the consensus forecasts in May. We were also surprised to see the RBA's employment growth forecast of only 0.75%, implying a full 1% rise in the unemployment rate over the next year. That is a dramatic slowdown in growth from 2.5% over the last year. It implies a 1% rise in the unemployment rate over the next year. Note that in the last two slowdowns with which a full 2% rate cut cycle was associated the unemployment rate rose by 0.6% (1995-97) and 1.1% (2000-01). The 1% rise that is currently forecast will be right at the Bank's threshold limit and represents around the biggest rise in the unemployment rate since the recession when it rose by 5.2% from 5.6% in December 1989 to 10.8% in February 1993.

The numbers in the forecasts were considerably 'down beat', if not the language. The language in the body of the SoMP tends to reflect staff views. The language in the Minutes will reflect the sentiment of the Board.

We are still attracted to a first move of 0.5% for a number of reasons.

• Most importantly is that the 'safest' time to cut by a larger than normal amount is at the beginning of the cutting cycle. The previous two easing cycles began with 0.5% moves. Starting levels were similar to the current starting level of 7.25% (7.5% in 1996 and 6.25% in 2001). The beginning of the cycle is the best time because that is the time when rates are the furthest away from neutral and clearly in contractionary territory. The risk of overstimulating is at its lowest when rates are furthest away from neutral. As the easing cycle progresses and rates become more stimulatory the risk of a large move overshooting becomes greater.
• The Bank has given the market ample time to prepare for this move. We will be most interested to assess from the Minutes as to whether there was a view that rates could be cut in August but delayed because markets were not prepared. A 50bp move in September would be seen as catch up for a move that was considered appropriate in August.
• The Bank's biggest concern appears to be the sudden collapse in credit growth. We agree that the slowdown is much more of a demand event than driven by supply. Cutting rates lowers borrowing costs and stimulates the demand for credit. That has already happened in the swap and bank bill markets. We assess that swap rates have fallen by around 70bp's since markets detected the RBA's intention to cut rates. In the last two days an RBA Assistant Governor and the Deputy Governor have both emphasised the need for RBA rate cuts to be passed on in full to variable rate mortgage borrowers. The experiences of the Bank of England which cut rates three times by a total of 0.75% only to see mortgage rates rise by 0.5% will be on the mind of the authorities.

The wording in the Board Minutes will be crucial in our review of the most likely size of the first cut.

However, the size of the first cut is much less important than the overall profile of the cycle. We have argued that it will be different to the last two easing cycles. These have been remarkably similar - lasting around 12 months and totalling 2-2.5% in cuts. These previous easing cycles coincided with inflation either well contained or actually falling. Policy could be pushed from contractionary to stimulatory without being too concerned about overstimulating. This time inflation will still be an issue early next year. The RBA will be aiming to restore credit growth to some more normal pace and then stop easing in the expectation that demand will still be soft; spare capacity will be emerging and inflation pressures can ease. The actual movement to neutral - 5.5% and possibly beyond - will be delayed until 2010.

Markets are currently pricing cash rates to be down by around 0.75% by year's end. We assess that as being about right (we expect 0.75%). They are also looking at one more rate cut by March - fairly close to our own view that rates will bottom out in the first stage of the cycle at 6.25% by March. They are also fairly conservative on the likely follow through on rate cuts from around March. It is certainly our view that rates will be stable for most of 2009 as the RBA resumes its inflation fighting rhetoric. For now markets are pricing a rate profile close to our view with the exception of the size of the first move.

Bill Evans, Chief Economist, Westpac, ph (61-2) 8254 8531

Australia: Data Wrap

Aug RBA Statement on Monetary Policy

• The Reserve Bank's August Statement on Monetary Policy maintained the theme that we saw in the Governor's Statement following the Board meeting on August 5. The same critical conclusion was quoted in the key Introduction section. That is, "scope to move to a less restrictive monetary policy stance in the period ahead is increasing." That is certainly enough to support the expectation that the RBA will cut rates in September. Given that our forecast is for a bold 0.5% cut, we were given little encouragement that the detailed wording (compared to the Governor's short Statement on August 5) supported bigger growth concerns. However, we continue to support the prospect of a September cut, and assess that because the Bank's major concern is with overly tight credit conditions, a 0.5% move would be the best policy.
• The most obvious place for the Bank to highlight its concerns is in their growth forecasts, which are made on a 'no policy change' basis. In that regard, growth in non-farm GDP to June 2009 was revised down from 2¼% to 1¾%. The Bank describes the forecast changes as "modest", which does not sit well with what appears to be a fairly major change in policy stance as implied by the indication that policy can be eased, so we tend to downplay its significance, particularly since it does not figure in the key introductory comments.
• There is plenty of evidence in the Statement that tight financial conditions are of concern to the Bank. This Statement refers to business credit slowing sharply: "a sharp slowing in credit expansion to both households and business". It also refers to "quite restrictive monetary policy". It also notes that "the most recent increase in mortgage lending rates can be expected to have some additional dampening effect."
• The Bank notes it is also expecting "a significant reduction in inflation over time". The forecasts are now expecting inflation to fall by 1.75ppts from December 2008 to December 2010, compared to the previous forecast that it would fall only 1.25ppts over that period.
• In this Statement, the Bank appears to be much more worried about the global outlook. Indeed a key risk to their forecasts is seen to be a further deterioration in the outlook for global growth, particularly if it is associated with a marked slowing in China and India. That would also provide further downside surprises with regard to inflation.
• The global capital markets remain a concern, with the Bank raising the possibility that the ongoing turmoil could exacerbate the slowing in domestic growth by further reducing the availability of credit.
• The language in this Statement is not strongly supportive of a September move, but the key sentence used by the Governor on August 5 is repeated. We are therefore entirely comfortable that the Bank intends to cut rates in September. We were given little encouragement for our 0.5% cut view in this Statement. However, we assess that because the sharp turnaround in sentiment from the Bank over the last few months is mainly due to the collapse in credit growth and credit availability, a bold move on the cash rate is the best strategy. We continue to hold that position, while accepting that, as with the bulk of the Governor's Statement, there is little in this Statement on Monetary Policy to signal such an adjustment. The detailed minutes of the August Board meeting, which will be released on August 19, will provide a clearer picture.

Aug Westpac-MI Consumer Sentiment

• The Westpac-Melbourne Institute Index of Consumer Sentiment increased by 9.1% in August from 79.0 in July to 86.2 in August.
• This is the third biggest jump in the Index in the last five years but it comes as no surprise. Apart from the last few months this is still the lowest read in the Index since June 1993.
• We are confident that the two most important variables which influence Consumer Sentiment are interest rates and petrol prices. In fact petrol prices have been the key driver of the Index since April. Over the three months from April to July mortgage rates were broadly steady but the Index fell by 10.1% to its lowest level since 1992. During that period petrol prices rose by 15%. Since the last Survey in July we have seen a very welcome 8% fall in petrol prices. We expect that the 9% surge in the Index has mainly been due to that sharp fall in petrol prices.
• The Reserve Bank Board next meets on September 2. Following the clear signals from the Governor's Statement we are very likely to see the Board cut rates. Financial markets expect the move to be 0.25% to be followed by another 0.25% cut in October. We think there is a decent case for a 0.5% move. The Bank has been unnerved by the sharp slowdown in the Australian economy and will be aiming to quickly offset the current downward momentum. The last two rate cut cycles have begun with 0.5% moves. That is not coincidental. With rates well in the contractionary zone at the beginning of rate cut cycles the risks of overshooting with a decisive move are much lower than when rates are near neutral.

Q2 wage price index

• The headline Wage Price Index was stronger than consensus but as we forecast in Q2, rising 1.2%qtr (consensus 1.0%) taking annual growth back to an equal record high of 4.2%yr from 4.1% previously.
• While beyond expectations, the result is unlikely to concern the RBA, particularly with their recent recognition of a softening in labour market forward indicators and an expected rise in the unemployment rate over the year ahead. The data remains consistent with the Bank's rhetoric on wage inflation in the August SoMP, with annual growth above its historical average, but not accelerating over the past year.
• The private sector WPI rose 1.1%qtr taking annual growth to 4.3%yr from 4.2%. The public WPI rose 0.9%qtr taking annual growth to 3.8%yr from 3.9%.
• A broader WPI measure than the headline series is for total hourly rates of pay including bonuses, which today showed a deceleration to 4.5%yr (vs 4.7% prev) for all sectors, with the private sector pace easing to 4.8%yr (vs 4.9% prev).

Aug MI consumer inflation expectations

• Consumers' inflationary expectations saw a welcome pullback in August, their first fall since April, no doubt helped by the 8% fall in petrol prices between surveys. The median expectation of consumers fell to 4.9% from 5.9% previously, the lowest since April. This fall failed to prevent the uptrend in expectations since January 2007 continuing, although the pace of uptrend was the slowest since January 2008. The inflation expectations of managers and professionals (collected since 1995) also pulled back markedly to 5.1% from 6.6%, the lowest since April, slowing its uptrend.
• The August RBA SoMP described inflation expectations as "at high levels, and an upward trend is evident across various measures." That uptrend has continued in August, although the Bank can take some comfort from the sharp headline pullback in the month and slower uptrend pace. The Bank also noted that in this survey, the median consumer expectation had jumped to "close to 6 per cent" in July from around 4¼% three months earlier in April - a 1¾ppt rise. That three-month comparison looks far less onerous this month, with the latest 4.9% level actually 0.3ppts lower than that seen three months ago (5.2%).
• In the detail, the proportion of consumers expecting inflation above the 2% to 3% target band fell to 67.0% from 73.9%, its lowest since April although still above its twelve month average of 64.7%. Simultaneously, the proportion expecting inflation within the band improved to 8.7% from 7.5%, the highest since May although still well below its twelve month average of 12.0% - so overall, a development for the Bank in the right direction, but 'baby steps' at this stage.

Aug Westpac-MI unemployment expectations

• Despite the solid rebound in August consumer confidence, consumers' unemployment expectations were only slightly less pessimistic in August. The unemployment expectations index fell 0.6% to 136.47 after a 3.2% rise previously. This saw their trend deterioration continue, although the pace of deterioration slowed. Their deviation from long run average levels remained in similar positive territory to last month at 11.2%. This leaves their level consistent with a steep deterioration in full-time employment growth through 2008H2, suggesting downside risk to our (recently downwardly revised) prognosis for a slowing in jobs growth to 1.5%yr by end 2008. We continue to expect a further slowing in jobs growth to a sub-1%yr pace in 2009, but this survey implies downside risk.

Q2 full-time AWOTE

• Full-time AWOTE (average weekly ordinary time earnings) rose just 0.7% in Q2 (and a 'soft' 0.7 at 0.65 to two decimals, lowest since 2006Q2) after a 1.2% rise previously, taking annual growth sharply lower to 3.7%yr from 4.8%yr previously. This takes the annual pace below its decade average growth rate of 4.54%yr for the first time since 2007Q2. Private sector AWOTE rose 0.8%qtr (vs 1.3% prev) taking annual growth to 4.2%yr from 5.4%. This took private sector growth below its decade average also (4.68%yr) for the first time since 2007Q2. Public sector AWOTE rose 0.5%qtr (vs 0.7% prev) taking annual growth to 2.6%yr from 2.8%.
• With the RBA also focussing on broader measures of wage inflation, further encouragement was provided by today's data on top of yesterday's slight slowing in growth of the broader WPI measure including bonuses. For the private sector, growth in full-time adults total earnings (not just ordinary time) remains stronger than that for AWOTE, but has fallen back to its decade average pace for the first time since 2007Q2. Private sector fulltime adults total earnings rose 0.8%qtr (vs 1.5% prev) taking annual growth to 4.5%yr from 5.7% previously - the decade average growth rate is 4.54%yr.
• AWOTE is a volatile measure of the average wage bill faced by businesses in a levels sense, and is often distorted by changes in the composition of labour in the survey sample. As such, it is not usually a good guide to short run wage inflation trends. But encouragingly for the RBA, these measures are no longer growing beyond the average pace seen over the last decade, and imply the beginnings of an easing in cost push wage bill pressures on businesses.

Round-up of local data released last week

New Zealand: The Week ahead & Economic Wrap

Where no-one gets a bargain

Retail spending in New Zealand remains weak, but not quite as bad as the market expected. Actual sales rose 0.9% for the month of June, while sales volumes fell by 1.5% in the June quarter. This was the second straight decline and the largest since the 1991 recession.

The fall in retail sales reflects the immense pressures operating on household budgets. Rising prices for food, petrol, and all associated products have left consumers with a severe reduction in purchasing power - spending on fuel alone was $359m higher in Q2 than a year earlier, leaving less to spend on other items. Moreover, falling house prices and finance sector closures and freezes have dented consumer confidence, despite solid wage growth and a still-tight labour market.

The auto sector has been hit particularly hard, thanks to higher fuel prices and reduced access to financing. In the three months to June, motor vehicle sales volumes fell 10.4% compared with the same period a year ago. There was a 5.2% rise in vehicle sales in the month of June, but this appears to be a technical bounce following a 14.6% drop in May - monthly car registrations show that the trend remains well and truly downward. Fuel sales were up 24% on a year ago, all of which was swallowed up by higher prices.

There was no single sector that accounted for the upside surprise in sales. In fact, the strongest single contributor was “other retailing”. Surprisingly, the second strongest contributor was appliances, with volumes up 1.3% (s.a.) in the quarter, though the dollar value was down slightly. This may support recent anecdotes of heavy discounting by some retailers, though there is little evidence of this happening in other sectors during the June quarter.

Any bargains there are to be found may prove to be short-lived. Local manufacturer Fisher and Paykel has already announced that it will increase its prices by up to 10% in September due to rising steel costs, and other producers are no doubt in the same boat.

All up, 2008 has turned into an annus horribilis for retailers, especially for sellers of big-ticket items, as they are squeezed from both sides. The consumer is currently under a lot of pressure, and even with the monetary easing now under way and the stimulus of tax cuts from 1 October, we expect spending growth to remain subdued for some time yet. On the other side, a net 79% of firms reported higher costs in the June Quarterly Survey of Business Opinion, and even with a record proportion of firms intending to pass on these costs to consumers, expectations of falling profitability are the most widespread in 25 years.

Like the rest of the world, New Zealand is facing a major cost shock, the likes of which many people will not have experienced before Sales volumes have fallen as sharply as they have precisely because prices are outpacing incomes. Of course, the implication is that if the cost shock were put in reverse - for example, if world oil prices were to fall even faster than the exchange rate - activity could pick up again surprisingly quickly.

Bargains have been surprisingly hard to find in the housing market as well. The REINZ figures for July showed a further rise in sales, when the normal seasonal pattern would have dictated a fall, and a sharp rise in the number of days to sell. Both of these figures are consistent with the backlog of unsold homes starting to clear, helped by lower mortgage rates in recent months. However, the median sale price was unchanged for the month and down just 1.4% on a year ago. Industry sources have suggested that sellers are becoming more “realistic” about their price expectations, but apparently that doesn't yet extend to accepting outright price falls. The Quotable Value measure of house sales, which is more accurate but less timely, shows that prices for the three months ended July were down 2.2% on the same period last year.

This week's figures have no real implications for monetary policy in the near term. The RBNZ began its easing cycle in July due to concerns that higher offshore funding costs would be passed on to households and businesses. Those concerns will still be valid in September - wholesale interest rates are already assuming an extended easing cycle, so a pause at this stage would risk becoming a de facto tightening.

The proviso in the RBNZ's July statement that “there is no excessive exchange rate depreciation” seems to have been a red rag to a bull for markets, with the currency down sharply in recent weeks. The RBNZ is likely to go into the 11 September review with the tradeweighted index averaging about 3% below their June projections. This is a sizeable miss, but not the worst they have ever faced, so we don't think it will prevent another 25bp rate cut in September. But if the currency were to continue to fall at its recent pace, a pause in October or December could become an option.

Round-up of local data released last week

Data previews

Aus Jun Westpac-MI Leading Index

Aug 20, Last: 2.1% annualised

• The annualised growth rate of the Westpac-MI Leading Index of economic activity, which indicates the likely pace of economic activity 3 to 9 months into the future, was 2.1% in May, well below its long term trend of 3.9%. The annualised growth rate of the Coincident Index was 3.0%, also below its long term trend of 3.8%. Both measures have shown a sharp turnaround since 2007, from well above average to substantially below average growth rates.
• Components were generally weaker in June. Dwelling approvals fell 0.7%. Money supply growth rose from 0.4%mth in May to +0.7%mth in June but will be marked lower in real terms following the 1.5% in the June quarter CPI. The sharemarket resumed its downtrend, the ASX200 falling 7.4% in June after the short-lived 1.1% rebound in May. On the international front, US industrial production rose 0.5% in June after falling 0.2% in May.

NZ Jul external migration ann.

Aug 21, Last: 4,700, WBC f/c: 4,600

• Net migration is currently low because many New Zealanders have been leaving for Queensland and Western Australia. However, elevated arrivals from Asia have offset the outflow of NZers, leaving migration fairly steady over the past few months.
• Migration on our expectations will be in line the RBNZ's forecasts. The RBNZ views migration as a crucial variable. Big changes in migration have the potential to change the monetary policy outlook rapidly.
• We expect annual net migration to trough at around 3,600 in November 2008. Net migration is expected to pick up in 2009, due to the weaker economies in Australia and the UK which could send NZers heading for home.

US Jul producer price index

Aug 19, Last: 1.8%, WBC f/c: 0.2%

• The PPI headline jumped sharply again in June, driven by surging gasoline prices and a steep rise in food prices. However the core rate was subdued at a steady 0.2%, suggesting no additional pressure on underlying consumer prices from the factory sector, despite soaring commodity prices.
• July saw a dramatic turnaround in commodity markets, with crude energy prices starting their descent into a bear market, allowing gasoline prices to fall; and food prices easing from their highs. But as July import prices and CPI data showed, the turnaround occurred too late to show up in July price data.
• That said, to the extent that July food and energy price gains affect the PPI, their impact should be limited. We expect a 0.5% headline gain, but another 0.2% core, although that, as always, is subject to potential volatility in new vehicle prices.

US Jul housing starts & permits

Aug 19, starts: Last: 9.1%, WBC f/c: -12.0%

Aug 19, permits: Last: 16.3%, WBC f/c: -20.0%

• Housing starts jumped 9% in July and permits, orginally reported up 11%, were subsequently revised to a 17% surge, as builders scrambled to beat the July 1 introduction of a new NY building code, lifting multiple starts by 242% in the north-east! But nationally, single family starts and permits (not impacted by the code) were down 5%/4% respectively - both to new cycle lows.
• The unwinding of this distortion in the north-east will be the dominating feature of the July report. A substantial number of starts/permits were pulled forward into June from H2 2008. That activity will no longer be recorded in July and subsequent monthly data, so we should see a cumulative 17% starts fall and 28% permits drop starting in July and continuing thereafter even aside from any further underlying weakness. If most occurs in July, expect a 12% starts slide and 20% permits plunge.

Westpac Institutional Bank
http://www.westpac.com.au

Disclaimer

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