Independent analysis of Australia's macro economy

Friday, February 8, 2019

Weekly note (8/2) | RBA shifts to neutral

The Reserve Bank of Australia (RBA) was the key focus this week, highlighted by its shift to a neutral policy stance from its long-held mild tightening bias. The Governor's statement that accompanied Tuesday's decision to leave the cash rate on hold at 1.5% contained no clear indication of this forthcoming shift, though it did signal a lower growth outlook for the domestic economy, and also noted an increase in "downside risks" for global growth, the latter regarded by the Bank as the predominant headwind. 

Wednesday's speech (titled: The Year Ahead) by Governor Lowe to the National Press Club maintained a positive assessment of domestic conditions pointing to expectations for "reasonable" growth; further progress in the labour market; strong infrastructure investment; and ongoing contributions from resources exports. However, it was an increased level of uncertainty around the outlook for household consumption and the housing market that has driven the shift of the Board. 

The key line from the Governor regarding the cash rate was that "over the past year, the next-move-is-up scenarios were more likely than the next-move-is-down scenarios. Today, the probabilities appear to be more evenly balanced." This assessment replaced the line used in preceding communications that "members continued to agree that the next move in the cash rate was more likely to be an increase than a decrease". Financial markets were surprised by the shift, and as shown in our chart of the week (below) have now fully priced in an expectation for a rate cut by February of next year. 

Chart of the week

Friday's quarterly Statement on Monetary Policy for February contained a detailed analysis behind the changes to the Bank's assessment of conditions. Updated forecasts (see here) confirmed the RBA has lowered its outlook for growth in the domestic economy in 2019 to 3% from 3.25% and to 2.75% from 3% in 2020. The near-term growth outlook was revised more heavily; growth for 2018 was expected to slow to 2.75% (from 3.5%) before easing to 2.5% (from 3.25%) by mid-2019. The Bank regards trend growth to be 2.75% to maintain stability in unemployment and inflation.

The lower growth outlook is conditioned on household consumption growth slowing to 2.75%, revised down from its previous expectation for 3%. This, in part, reflects the impact of statistical revisions over recent years, though it was notable that the Bank is now prepared to allow for some downward impact on consumption growth from declining property prices. Growth in households' disposable income, which the Bank regards as having a greater impact on consumption growth, was also expected to increase by around 2.75%.

The other main downside risk comes from a sharper slowdown in residential construction activity. The Bank now expects dwelling investment to contract by 4.5% (from -2.4%)  in 2019 and by 5.3% (from -2.4%) in 2020, which acknowledges an increasing deterioration in building approvals and tighter financing conditions.

The Bank expects growth in the domestic economy to be driven by business investment, supported by non-residential construction and a gradual lift in mining investment, public demand in infrastructure and services, and resources exports. Stronger-than-expected conditions in the labour market were also positive, while wages growth was forecast to lift gradually.   

In line with the slower growth outlook, the Bank adjusted its outlook for the unemployment rate, which is expected to take a little longer to tighten below 5%, while the pace of employment growth in 2020 was revised lower. Accordingly, inflation is now forecast to return to within the 2-3% target band in 2020 — a year later than previously expected — though weaker oil prices and slower increases in utilities and other administered prices were contributing factors.   

The key developments the RBA will be focused on this year are around the household sector, notably the impact of declining property prices on spending decisions, housing market activity, labour market conditions, and rising uncertainties abroad. 

In other local events, the domestic data flow remained decidedly disappointing this week. Building Approvals contracted by a sharp 8.4% in December, with weakness evident across all dwelling types (read our analysis here). The deterioration in building approvals gathered pace over the second half of last year and points to an increased risk of residential construction becoming a headwind to growth in the domestic economy over the next couple of years. Retail spending slowed at a sharper-than-forecast pace in December, posting a decline of 0.4% (see here). Though seasonality did appear to impact the result, the detail also contained indications of softening dynamics around the consumer, potentially in response to ongoing declines in property prices, while retail volumes increased by just 0.1% in the quarter pointing towards a subdued contribution from household consumption to GDP growth in Q4. International trade data for December showed a greatly increased trade surplus in the month, though that was driven by weaker outcomes for both exports and imports (see here). With stronger commodity prices over the quarter resulting in a boost to the nation's terms of trade, a reduced contribution to growth from international trade in Q4 appears likely.

Also this week, the final report of the government inquiry into the nation's banking and financial services sector was released. The key recommendations of the report tabled by Commissioner Kenneth Hayne were focused around enhancements to the regulatory environment, with ASIC and APRA set to be overseen by a newly-established independent body. Wide-sweeping changes to overhaul fee structures across the financial services industry were recommended, though report contained no recommendation for an enforced separation for providers of both advice and wealth products. From a macro perspective, Commissioner Hayne indicated that no further changes to tighten existing lending laws were required, noting the improved compliance measures already taken by the banks in this area.

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It was an unusually quiet week for global markets with few major events or data releases on the calendar. Market closures for Chinese New Year holidays also kept Asian trade thin across the week.

The European Commission lowered its forecasts for economic growth in the 19-nation euro area for 2018 (from 2.1% to 1.9%), 2019 (from 1.9% to 1.3%) and 2020 (from 1.7% to 1.6%), reflecting weaker output from global trade, contracting car production in Germany and social and political tensions. Sharp downgrades were expected in Germany, the euro area's largest economy, where growth is forecast to slow to 1.1% in 2019 mostly in response to major changes occurring in the auto sector to meet emission targets that have impacted output, and also in Italy, the third-largest euro area economy, where uncertainty over government fiscal policy was expected to restrain growth to just 0.2% over the year. Weaker oil prices also resulted in inflation forecasts declining to 1.4% (from 1.8%) this year before lifting modestly to 1.5% (from 1.6%) in 2020.

The Bank of England maintained policy settings in line with expectations at its latest meeting on Thursday. The key development was that the Bank sharply lowered its forecast for growth this year from 1.7% to 1.2%, which would be the slowest pace since the financial crisis, and from 1.7% to 1.5% in 2020. The Bank highlighted "an intensification of Brexit uncertainties" as having notable impacts on business investment and exports. 

Sentiment around a global trade resolution turned down this week when US President Trump confirmed he did not plan to meet with China's President Xi before March 1, which is the deadline to reach a trade deal to prevent an increase in the tariff rate from 10% to 25% to US$200bn of Chinese imports to the US.