The forecasts in the SOMP assume the two more rate cuts which are currently in market pricing and yet the forecasts have deteriorated; this has generated some discussion from the Governor around unconventional monetary policy.
The RBA updated its forecasts in the August Statement on Monetary Policy (SMP), as foreshadowed in the August policy decision statement. The forecast period has been extended from June 2021 to December 2021.
For real GDP growth, the RBA has revised down its forecast for 2019 from 2¾ per cent to 2½ per cent, in line with our preview. That is not surprising given that growth in the first half of 2019 is likely to print around 1 per cent, making the previous forecast of 2¾ per cent highly unlikely. However the RBA has retained its forecast for 2020 of 2¾ per cent, which is around trend growth. Westpac still sees those forecasts as too high, favouring 2¼ per cent for 2019 and 2½% for 2020. For 2021, the RBA has upgraded its growth forecast to 3 per cent from 2¾ per cent in the year to June 2021 previously and has extended that 3 per cent for the whole of 2021.
For underlying inflation, the previous forecasts were 1¾ per cent in 2019, 2 per cent in 2020 and 2 per cent for the year to June 2021. The RBA now expects inflation to be 1½ per cent in 2019, 1¾ per cent in 2020 and then 2 per cent in 2021. This follows outcomes of 0.3% and 0.4% for the opening two quarters of 2019. We welcome the cautious approach to the new 2020 forecast, recognition that the RBA will likely miss the 2-3% target band for another year.
However we need to see these “rounded” forecasts in the context of the detailed forecasts which are provided in the Appendix. For these forecasts the “trimmed mean” inflation rate for 2020 is forecast at 1.9% and 2.1% in 2020.
In May the unemployment rate was forecast to hold at 5 per cent to December 2020 before falling to 4¾ per cent by June 2021. Recall that the new starting point for these forecasts is 5.24% for June 2019, posing a challenge to reach 5% when the forecast growth rate is below trend in 2019 and only at-trend in 2020. The new forecasts have the unemployment rate at 5¼ per cent in 2019 and again in 2020, then edging down to 5 per cent in 2021. Such a forecast is well above the Governor’s estimate of full employment of 4.5%.
The RBA is now forecasting less progress on the inflation and unemployment targets than had been expected in the May SMP, which assumed two rate cuts by year’s end. And of course, we must bear in mind that these new forecasts are based around market pricing which now includes two 25bp rate cuts having been delivered and pricing for two additional cuts (one by end 2019 and one by mid-2020). In addition, the May forecasts assumed an AUD of USD 0.70, compared to 0.68 currently.
The most important observation from these forecast changes is around wages growth. The forecasts in May included the wage price index to increase by 2.5% in 2019 and 2.5% in 2020. These forecasts have now been lowered to 2.3% in both years. This is despite the underlying assumptions of lower interest rates and a lower currency. The motivation behind this decision which must be very disappointing for the RBA Governor given his strong focus on lifting wages growth is firstly due to the RBA’s own liaison program which shows that the majority of firms anticipate little change in wages growth over the next year. This adjustment also reflects the increase in the forecast for the unemployment rate from 5% in both end 2019 and 2020 to 5.2% for both years, indicating more spare capacity in the labour market than had previously been expected. This forecast slowdown in wages growth is one of the major factors behind the downward revision in the inflation forecasts.
The second important change in the forecasts is around household consumption growth. These forecasts have been reduced from 2.0% (2019) and 2.6% (2020) to 1.5% (2019) and 2.4% (2020). These downward revisions reflect the slower than expected consumption growth, already registered this year and the associated lower growth rate for household incomes in 2019.
While the RBA emphasises downside risks to the forecasts from international developments, it is surprising that the actual forecasts include no adjustments to major trading partner growth, remaining at 3.7% in 2019, 3.8% in 2020, and 3.8% in 2021.
The most important positive development which is cited in the discussion is around the earlier than expected stability in the housing market. While the downturn in activity is forecast to be weaker than expected in the May SMP in 2019 (-9.0% compared to -6.7%), there is a marked boost to the construction outlook for 2020 with the previously forecast downturn being reduced from -5.7% to -3.3%. This rebalancing of the cycle partially explains the lift in growth in 2020 relative to 2019.
Despite concerns about the impact of global developments on business confidence, the broad profile of expected business investment growth is unchanged. While the theme that public spending growth will remain solid but slow down somewhat also holds.
In summary, the key themes from the forecasts and the tone of the economic commentary includes a slower wages and inflation outlook, complemented by a higher path for unemployment, leaves the way open for more monetary stimulus. We remain comfortable with our current forecasts that there will be another cut in October to be followed by a move to a 0.50% cash rate in February next year.
The Statement on Monetary Policy was not the only missive from the Reserve Bank today. We also saw an appearance by Governor Lowe and his senior team before the House of Representatives Standing Committee on Economics.
This appearance must be considered in the context of a Governor who despite assuming two more rate cuts for the purposes of his forecasts, is still not expecting inflation to return to the 2–3% target band before 2021, and similarly is not anticipating any progress in reducing the unemployment rate (which is now higher than three months ago) until 2021. The outlook for unemployment will be particularly disappointing given the Governor’s recent revelation that we should be aiming to bring unemployment down to around 4 ½ per cent.
Naturally, these circumstances triggered a number of pointed questions around the RBA policy outlook from the Committee. Firstly, Governor Lowe noted “It’s possible that we end up at the zero lower bound, I think it’s unlikely, but it is possible. We are prepared to do unconventional things if the circumstances warranted it. I hope we can avoid that. It’s clearly prudent for us to be thinking about it given the global forces that I’ve talked about before”. (Source: Bloomberg)
To emphasise that the RBA has been considering unconventional policies he goes on to itemise a number of policies that have been used overseas, while noting that some policies would not be appropriate and emphasising that policies should be adapted to the specific circumstances of the country and the nature of its financial markets. In particular Australia is not and is highly unlikely to be facing a liquidity crisis; this policy is targeted at strengthening the impact of lowering the cash rate.
Nevertheless he does seem to give most attention to the strategy of lowering the risk free rate right across the yield curve (government bonds).
He also acknowledges that a package of measures works best.
On July 24 Westpac lowered its forecast for the terminal cash rate from 0.75% ( to be reached in November) to 0.50 % to be reached in February 2020.
We also pointed out that the move from 0.75% to 0.5% could be linked to a package of other policies that would be designed to strengthen the pass through from the lower cash rate to the variable mortgage rate and other private sector rates. This would be largely achieved by the RBA providing secured long term funding facilities to banks and other financial institutions at the overnight cash rate. This policy had been adopted by the Bank of England in response to concerns around the Brexit vote in June 2016 (policy implemented in August 2016) when it cut the bank rate from 0.5% to 0.25%.
The policy successfully lowered private sector rates including an eventual full pass through of the lower bank rate to variable mortgage rates. Attractive low cost liquidity also had the effect of lowering other interest rates including government securities as these institutions were encouraged to use the attractive funding.
The attractiveness of this policy prescription was that it was seen as a package of policies aimed at lowering rates, both public and private, right across the spectrum.
The Governor’s objective of lowering longer term rates would be helpful but, given the bulk of private sector debt in Australia is linked to short term rates, a policy to strengthen the impact of the lower cash rate directly on short term private sector rates would be more effective and appropriate for Australia’s particular financial system.
At the time, we indicated that such a policy could not be expected in the near term and it certainly sounds as if the Governor is some way (including implementing more conventional easing ) away from using unconventional policies but his remarks today have certainly given us some encouragement that a “package” of unconventional policies might be used to complement conventional policy at some stage in this cycle.
While these responses are encouraging for our view other details of his speech were less encouraging. He indicated that, at this stage, the RBA would not adopt an unconventional package until the cash rate had been reduced to 0.5% and seemed to emphasise that a sharp deterioration in global or domestic economic conditions would be necessary to trigger unconventional policies.
Our theme which we released on July 24 was focussed more on the need to strengthen the impact of rate cuts in a situation of extremely low rates rather some global or domestic crisis.
There is plenty of time for the RBA to consider the benefits of unconventional policies outside some crisis situation.
For now, we are comfortable to retain the themes from the July 24 note.