The RBA has kicked off the decade with their rose coloured glasses on full tint. The RBAs economic forecasts released earlier this month were optimistic and the tone in recent communiques decidedly upbeat. Today’s minutes of the February 4 board meeting outline that the board considered the case for further cuts in the cash rate but remained reluctant to take it lower. Despite this reluctance, the minutes had a more dovish slant than the corresponding statement. And even though the RBA remain optimistic on the trajectory for the economy, they still inject a dose of reality noting rates will be low for a long time.
“The Board also recognised that the incremental benefits of further interest rate reductions needed to be weighed against the risks associated with very low interest rates.”
The boards hands are being tied by the impact of lower rates on asset prices (rate cuts injected a lifeline to previously struggling property prices), savers and financial stability. Noting that lower rates could “encourage additional borrowing at a time when there was already a strong upswing in the housing market”. But if we cast our minds back to last year, it was not just the impact of rate cuts that lent a tailwind to property prices. Momentum was spurred by APRA’s lowering of the mortgage rate threshold for banks and the removal of policy uncertainty as the Liberal coalition party claimed election victory in May.
After cutting policy rates 3 times last year, the RBA are also waiting for the lags in policy transmission to play through. Stating, “ the Board took into account that interest rates had already been reduced to a low level and that there are long and variable lags in the transmission of monetary policy."
Households remain cautious and spending is anaemic, despite interest rates being cut to a record low and tax cuts, consumers are choosing to save more and reduce discretionary spending. Even as house prices have risen again nationally, and even more so in Sydney and Melbourne, any positive wealth effect is counteracted by high household debt levels and weak income growth. At present, concerns about the outlook for the economy, particularly with the added coronavirus risks, job security and stagnant wage growth are outweighing any positive wealth effect from property prices on the rise again. Without income growth this dynamic is likely to persist for a protracted period even as house prices recover, hence pointing to a weak outlook for private consumption and continued policy easing. In our view it is not a case of “if”, but “when?”.
The RBA expects this dynamic is subject to a long policy transmission lag and that it will eventually reverse, with growth in household consumption picking up throughout the second half of this year. Whether this is a classic case of the RBA’s notoriously optimistic stance, time will tell. The minutes clearly show that the door is open for continued easing should the economy begin to diverge from the RBAs mooted turning point. And consumption which accounts for almost 2/3rds of the economy will be a key measure.
This is even before accounting for the impact of the virus outbreak which is only going to present additional downside risks. The only uncertainty in this respect is how much of downside risk this threat presents, given the huge question mark over the reliability of all data relating to COVID-19 cases in China. This means that within any forecast outcomes should be embedded an enormous degree of variability and the situation continues to remain very fluid. The question for the RBA, in assessing the case for continued easing, will be to what extent can they look through any hit from the virus outbreak. And does it merely delay, not derail, their forecast recovery.
Turning to the labour market, which remains a key measure for the RBA, and one that could see the central bank put aside their financial stability concerns in favour of further easing. Speaking on monetary policy at a parliamentary panel earlier this month, Lowe detailed the importance the unemployment rate in the future path of monetary policy. Whereby a rising unemployment rate will prompt continued policy easing.
“At the moment, the risks have slightly tilted to outweigh the benefits,” …“But, that could turn, particularly if the unemployment rate deteriorates.”
If participation trends lower throughout 2020 this could help the RBA in moving toward a lower unemployment rate if the pace of hiring continues. The problem is that jobs growth is also poised to slow in 2020 which will prevent the unemployment rate from moving lower. This is of particular concern in the wake of the devastating bushfires and uncertainties surrounding the economic impact on Australia of the coronavirus outbreak. The share of exports to China, both goods and services, relative to GDP renders the Australian economy one of the most China dependant economies globally. More than 30% of total exports go to China. Several quarters of below trend economic growth, along with weak consumer spending and heightened uncertainties presents a deteriorating outlook for the labour market and employment growth. Other forward look indicators of labour market health like ANZ job ads, capacity utilisation and vacancies also point to weakness in the labour market ahead and reduced demand for labour, pre virus outbreak.
Another significant hurdle for the RBA is the substantial spare capacity within the labour market, preventing material upward pressure on wages. Underutilisation will need to fall considerably before seeing a material uptick in wages, that can in turn boost household incomes and spur inflationary pressures.
Unemployment still remains well above the RBA’s estimate of full employment of 4.5% needed to spur wage growth, which is likely lower if we look to international examples (e.g. US, UK, NZ). And with unemployment set to remain elevated and labour market conditions to deteriorate in 2020, further stimulus will need to be injected into the Australian economy for the RBA to progress toward their full employment and inflation objectives, particularly whilst the government remain reluctant to loosen the fiscal purse strings.
Given that strength in the labour market is crucial in determining the RBA’s next policy move, and that many leading indicators suggest recent labour market upside surprises will soon drop off with unemployment rising again, we can expect a further easing from the RBA. And with the lower bound fast approaching, and further rate cuts on the way if, as we expect the labour market deteriorates, the unconventional policy debate will only grow louder.