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Why the Reserve Bank will cut the cash rate twice

This note confirms the forecasts we released on 24 July that the RBA will cut the cash rate by 25 basis points (0.25%) on 1 October and again by 25 basis points on 4 February 2020.

That call updated our previous call on 24 May when we were the only forecaster (Bloomberg Survey on that day) to argue that the cash rate would fall below 1%.

We were feeling decidedly lonely with our October call

Over the last few weeks, markets had lost confidence in the October view. On 13 September, markets priced an October move with a probability of only 26%.

Over the course of last week, markets have moved to an 80% probability of this move.

What changed over the week?

The most important development was the release of the September RBA Board minutes. We were encouraged by the sentiments in the minutes.

Following the release of the minutes I wrote:

“The minutes of the Reserve Bank Board’s September meeting contain similar themes to the August minutes but indicate that the Board acknowledges that it is getting closer to its next move on policy.

In August the Board minutes concluded that: “Having eased monetary policy at the previous two meetings, the Board judged it appropriate to assess developments in the global and domestic economies before considering further change to the setting of monetary policy. Members would consider a further easing of monetary policy if the accumulation of additional evidence suggested this was needed to support sustainable growth in the economy and the achievement of the inflation target over time”.

In these minutes there is no reference to previous actions. Arguably reference to previous actions is a clear sign that the Board is content to observe developments whereas not referring to previous actions there is less emphasis on the need to wait.

It is also interesting that the theme that drove the June and July decisions to cut rates: “the Australian economy could sustain lower rates of unemployment and underemployment” was repeated in these minutes whereas that particular theme was absent in the August minutes.

Impacts on the monetary policy decision

The minutes refer to three “developments that had a bearing on the monetary policy decision”.

  • The labour market – strong employment growth was recognised but the unemployment rate had remained steady at 5.2% (recall that the Governor has noted on other occasions that he would like to see the unemployment rate at 4.5%) and that wages growth “had remained low”. Indeed, the minutes point out that “the upward trend in wages growth appeared to have stalled”. We are aware that the Governor sees rising wages growth as the key to a sustained lift in spending growth and higher inflation. In addition, the minutes noted that “forward – looking indicators had continued to suggest that employment growth would moderate over the following six months”.

  • The housing market – it was noted that there was “a turnaround in established housing markets” but from the perspective of economic activity there was “further weakness in dwelling investment in the near term” and low turnover in the housing market meant that “spending on home furnishings and other housing related items was not expected to contribute to consumption growth in the near term”.

  • GDP growth – the Board meeting was held the day before the release of the June quarter national accounts. When the RBA released its forecasts on August 9 it was expecting GDP growth in the June quarter to be 0.8%; in the minutes it referred to an expectation of 0.5% due to the weakness of the partials in the lead up to the release. That forecast proved to be correct, but the minutes did note that “private final demand was expected to be weak”. (In fact, it was flat in the June quarter and down 0.4% for the year! – “weak” is probably an overstatement of the state of final demand).

With two meetings now having passed since the last move and, from my perspective, most importantly, the key rate cut theme that “the Australian economy could sustain lower rates of unemployment and underemployment” returning to the narrative, our central view that there is no reason to wait until November for the next move still seems reasonable.

Westpac continues to predict cuts in the cash rate of 25 basis points in both October and February next year.

Influence of the Fed

The second development in the week was the decision by the Federal Reserve to cut the federal funds rate by 25 basis points.

While this was a widely expected move it would have emphasised to the RBA, that following with the previous week’s move from the ECB global rates are falling.

Further, although there were apparent differences amongst Committee members the Chairman appears to be favouring policies that will maintain the expansion.

Chairman Powell saw “high value” in sustaining the expansion and was clear that “history teaches us it is better to be pro–active in adjusting policy”.

This approach indicates to us that, given our forecast is that growth will slow below trend through late 2019 and in 2020 the Fed is likely to be decisive in supporting the economy.

Implications of Australian employment

Finally, we saw the Employment Report for August last week. Note that the minutes emphasised the labour market as continuing to be central to the policy outlook.

The August Employment Report would have been very disappointing for the RBA although it reported a 37.4k gain in total employment. That is because the unemployment rate rose to 5.3% from 5.2% in July – a disappointing development given the strong increase in jobs (recall the Governor’s informal “target” of 4.5%, which he adopted when the unemployment rate was 5%).

It is important to remember how the results of the release are compiled. From the household survey, the ABS derives the various ratios on labour market performance; including the unemployment, underemployment, participation and employment to population ratios. These are which are then applied to an estimate of working age population to generate the level of employment, unemployment, underemployment and labour force.

Consequently, employment is likely to lift as population estimates pick up. This is why the recent softness in the labour market is being highlighted by rising unemployment rather than employment growth since those ratios in the household survey have been deteriorating.

The pace of growth in employment, and the change in participation, are correlated so it is not surprising that participation has lifted as employment remains robust – a strong labour market will bring more workers back into the labour force. But what is surprising this time is that the gains in participation are outpacing those for employment hence the trend rise in unemployment. This suggests that workers are entering the workforce due to a need for more income rather than only because employment conditions are improving.

If we focus on ratios, we can also see that the underemployment rate has lifted from 8.2% in June back to 8.6% in August.

We think the RBA is now firmly on board with this approach to assessing the labour market- strong jobs growth really reflects rising population and higher participation whereas the rising unemployment and underemployment rates are the true measures of the state of the labour market and its spare capacity. And of course, rising spare capacity puts downward pressure on wages growth (note in the minutes that the Board accepted that the upward lift in wages growth had recently flattened out).

Is the next one in February?

A realistic question is whether the follow up cut to the October move could come earlier than the February we currently expect.

One of the reasons why we argued consistently for October over the consensus view of November was that if global conditions deteriorated sharply near year’s end the RBA would like the flexibility to move again.

We think that the response of the Westpac Consumer Sentiment Index (down 4% in July as households seemed to be unnerved by consecutive moves) precludes another back to back move so going in October leaves available the flexibility to move in December. Waiting until November loses that flexibility.

We think the RBA would see the move to 0.5% as the low point in the cycle after which unconventional policies might be required. A prudent wait for that last move until early next year seems the most likely option.

Finally, Governor Lowe is scheduled to speak on the evening of 24 September. His speech on 21 May effectively signaled the rate cut which was delivered at the 4 June Board meeting.

Markets will be closely watching that speech.

 

Bill Evans is the Chief Economist at Westpac Institutional Bank. This material contains general information only. It does not constitute investment advice.

The forecasts given above are predictive in character and whilst every effort has been taken to ensure that the assumptions on which the forecasts are based are reasonable, the forecasts may be affected by incorrect assumptions or by known or unknown risks and uncertainties. The results ultimately achieved may differ substantially from these forecasts.

 

12 Comments

Ian P

September 29, 2019

A decade of low interest rates and QE has proven deficient stimulating world economic activity. It has inflated asset prices including bond prices to ridiculous levels, resulting in negative yields. When will governments realize monetary policy isn't working? Governments need to stimulate economic activity by spending wisely on needed infrastructure which will stimulate economic activity and provide an economic benefit.

Looking at Australia, the problem for the RBA, if Australia's interest rates are materially higher than the rest of the world the Australian dollar will be over valued resulting in Australian goods and services being less competitive. As for spending money wisely to stimulate economic activity and receiving future economic benefit two major projects come instantly to mind. Water and cheap base load power generation and distribution. No doubt there are many more. To raise the funds for these and other projects sell existing infrastructure while asset prices are inflated.

Jerome Lander

September 29, 2019

It is difficult to argue that a further cut in interest rates here and now is in our long term interests as a country (nonetheless, we will probably get one). House prices are already rising again. Cutting rates further is simply promoting further wealth inequality and an extension of asset class bubbles - such as in housing - and is doing precious little to support the underlying economy, other than weakening our currency. At very low interest rates, debt is already very cheap. Australians are already saddled with large amounts of debt and low wages growth prospects, and hence shouldn't be encouraged to be irresponsible with further debt-fuelled consumption spending. Instead, we need a more productive economy and real wages growth - it is structural reform and better governance which is really desperately needed.

charles

September 28, 2019

Lower rates for retirees means lower spending. How about the government responding by bringing back the discount on mandatory super withdrawals as was done in the GFC. We are motoring through our retirement capital by being forced to take out too much and then worrying about running out of funds. So, instead of taking out 6% of my super assets, make it 3% this year. I might even then contribute a bit more to the consumer market

Trev Astley

September 28, 2019

The Reserve Bank is a one trick pony - they need to have control over other facets of the economy which affect the whole population not just the mum's and dad's.
Adjusting fuel tax and gst would be more effective tools.
Nobody is talking about the theft going on with taxes that are indexed to inflation - Eg alchopops tax and many others.
Exploiting the 8th wonder of the world - Compound Interest.
The Taxman is squeezing us to death like a giant Carpet Snake.

Warren Bird

September 29, 2019

The RBA knows that it only has control of one lever of policy, albeit a powerful and important one. The Government has control of all the others, hence Phil Lowe's calls for other policy changes to support what monetary policy is trying to do.

AlanB

September 27, 2019

There are multiple dangers for the RBA in cutting interest rates when there is no urgency to do so:
- each rate cut has less effect than the last rate cut
- each rate cut encourages borrowing from people who did not qualify for loans before, who are marginal borrowers at best and most prone to mortgage stress
- each rate cut brings the RBA closer to 0%, when it will have no more rate cuts left in it armory to implement monetary policy.
But the biggest danger of all will be the howls of protest from the media and parliament and the immense political pressure that will be brought to bear on the RBA when it inevitably comes time to raise rates from these historic lows. No one resists the RBA when it cuts rates but if the RBA does not have the power or guts to raise rates when the need arises then it has lost control of monetary policy.

Warren Bird

September 28, 2019

AlanB,

if it's not needed they won't do it. Why do so many people presume the RBA is stupid or irresponsible?

And if they get to zero that isn't the end of their options. They just buy long dated securities instead of short-dated ones and set a quantitative target for the volume of those purchases instead of an interest rate target. That's the essence of QE. It's not weird science, it's just monetary policy (buying and selling securities in the market) when the nominal short rate gets to zero.

Which they will only do if it's going to be needed and helpful. Again, they actually do have the best interests of the Australian people and our economy at heart, I believe. They don't do this stuff just for fun.

Graeme

September 27, 2019

I think the key comment is, "In these (RBA) minutes there is no reference to previous actions." That certainly makes sense. It means that they can continue, with limited justification, a policy that raises asset prices but not demand. All the while cheered on by myriad commentators, most of whom come from organisations that have a vested interest in the aforementioned asset price inflation.

CC

September 26, 2019

Cutting interest rates will not boost consumer confidence or spending or improve the economy. it will prop up the excessive property market which is not what we need. a far more effective measure would be to reduce income taxes.

Peter Ewers

September 26, 2019

The world is currently awash with cheap debt, but other than perhaps staving off recession it does not seem to be doing much else. RBA wants companies to take advantage of the cheap credit in invest and employ more staff, but given the weak consumer demand and stock levels, I can’t see that happening even if rates fall another 0.5%. The only impact could be higher property prices in an already overpriced market.

At some point all of this cheap debt is going to implode. Maybe Bill can tell us when.

stefy

September 26, 2019

I can never recall the RBA in the past, until the last 12 months, setting interest rates according to unemployment rates. IMO it's just an excuse.
I would like to add that I'm just an old bloke living in suburbia, but every instinct in my body tells me that these ultra low and negative interest rates are going to end in disaster. I really believe its sheer bloody madness.

Barry

September 26, 2019

Bill Evans always talks interest rates down. It just defies logic. Cutting rates now will not, as has been recently demonstrated, boost the economy. Rates are already too low -- we should be trying to influence them up.


 

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