The Reserve Bank of Australia (RBA) decided to lower its cash rate by 25 basis points at its October 1 meeting. This was the third reduction in its benchmark cash rate in 5 months. RBA Governor Dr. Philip Lowe, in his statement, has reiterated that it is reasonable to expect an extended period of low interest rates. Also, based on the recent RBA statements and commentary, the central bank now stands very close to its perceived lower bound on the benchmark cash rate. Market participants are widely expecting at least one more cut in the cash rate and thus a possible exhaustion of its conventional monetary policy ammunition. Much to the discomfort to the apex authority, this could force their hands to introduce a first of its kind Quantitative Easing program in Australia to propel economic activity. We present the current economic scenario for Australia and its implications for the cash rate and the Australian dollar.
How have the domestic fundamentals unfolded this year in Australia?
Early in September, the June quarter national account figures had showed that this is now the worst annual economic growth in 18 years! The annualized GDP growth in the national accounts figures (released by the Australian Bureau of Statistics) dipped to 1.4%, which lies comfortably below the decadal trend growth rate of about 3%.
Opinions vastly differ on the reasons behind witnessing such weakness, but probably the most concerning of them all has to be domestic consumption demand. Though the current gloom seems to be far more wide-ranging than that, including the recent International trade developments, weak private sector, marginal wage growth and severe drought effecting farm produce in South-east Australia. In-fact, many of the widely cited indicators of business health and robustness in the overall private sector started showing a steep degradation around 3Q 2018, as shown in the following chart.
Starting first quarter of 2020, we expect a pickup in business activity and some front loading of capital expenditure on the back of record low interest rates. Resources and mining sector may not show a robust recovery as long as we observe softness in the Chinese economy.
Developments in the Labor Market
Much attention has been laid on the labor market developments this year. In fact, at this very point, the rate of unemployment is probably the single most dominant factor in the RBA reaction function. Labor market has broadly been strong just like United States. However, despite the strong job numbers in the last two years and labor participation rates sitting at record highs, somehow it has failed to translate into a lower unemployment rate and spur wage growth.
But there have been some big structural shifts in the labor market. For example, the share of the temporary workforce out of the total labor employed had gone up to a record 33%. According to the monthly labor market update, released by the Australian Bureau of Statistics, a total of 1,331,000 jobs have been created in Australia since the start of 2015 (post the end of mining boom in late 2014). A total of 538,700 out of these jobs have been part time in nature, i.e. roughly 40%, a very displeasing statistic from RBA’s perspective.
Wealth effect also played a big role in these structural shifts during the last 3 years, as the property epicenters in Sydney and Melbourne started to cool off since the start of 2018 and went into a slump by the end of year. It is only fair to assume that this ought to have pushed a portion of workforce, especially the female workforce into the labor market. This is pretty evident with the female participation which stands at a record high as of today.
We expect further improvement on the unemployment rate front over the next couple of quarters. At the same time, we don’t expect it to reach the RBA- perceived NAIRU (Non-Accelerating Inflation rate of Unemployment) of 4.5% in the foreseeable future, and hence any progress on the wage front should be minimal.
Need for weaker AUD forcing RBA’s hand
Much of how the Australian economy performs in the short-term (assuming no sizable changes in factors like the labor market and the capital deployed) rests on the shoulder of the Australian dollar i.e. AUD due to the heavy contribution of exports in the total Australian GDP. In fact, it wouldn’t be an over-statement to say that the Aussie dollar is the magic pill that had rescued the economy from the hinges of a recession every time in the last 3 decades.
It is important to realize that it is exactly this nature of dependency on the currency during turbulent times that puts an added pressure on the RBA to lower rates in tandem with the major central banks of the world. To quote from Governor Lowe’s speech titled ‘An Economic Update’, dated Sep 24:
“We live in an interconnected world, which means that we cannot completely insulate ourselves from long-lasting shifts in global interest rates.”
RBA watchers will remember how different he sounded when things were the other way around, i.e. when the Fed was delivering rate hikes in 2017 and 2018.
“We do not move in lockstep with other economies.”
He had firmly and clearly reiterated his stance whenever he was questioned whether the RBA could respond with rate hikes like other central banks.
A lot of it has to do with the international competitive advantage that the country’s exports receive with a weaker currency, and the resulting revenue gains that follow from its major commodity exports.
The chart above clearly depicts how the country has received sizeable windfall gains in the past two years on the backdrop of a weaker currency (AUD, in this chart, is inverted depicting weakness by upside movement). This has also helped Australia achieve a positive budget balance for the first time in more than a decade.
We expect that the AUD will continue to remain an important element on RBA’s reaction function. Other major central banks going for steeper rate cuts on the backdrop of rapidly slowing global growth remains a major risk for AUD and thus, the RBA. Steeper rate cuts elsewhere could translate into unwanted strengthening forces onto the AUD, and the RBA may have to unwillingly counter it through further monetary easing.
Did RBA miss the trick by not acting earlier?
It’s evident that the RBA forecasts on the major economic indicators in the recent few quarters have consistently turned out to be overly optimistic. Now, such upbeat tones and missing the forecasts isn’t something new to the central banking arena, but in the case of RBA it certainly translated into delay of policy action.
There is no denying that their estimates on the remaining labor market slack were wrong by a huge margin though labor market slack is not a truly quantifiable variable and is based more on anecdotal reference.
By a lot of economic metrics, RBA should have been much more pro-active with their policy action. Worried, perhaps, on account of limited monetary policy ammunition, RBA tried to stay low and relied too much on wishful thinking. Other central banks moving on the dovish end of the spectrum was perhaps the swing factor.
So, did RBA not coming to the rescue at the right time cost Australia a deeper slump, and perhaps its first recession in three decades is the big question. It’s no secret that the RBA kept appealing for more and more fiscal stimulus from the government. Finally, in June, when RBA, the government and APRA (Australia Prudential Regulatory Authority) delivered a three-way booster (in the form of a rate cut, a tax booster and some housing regulatory easing), Australia was already amidst deeper troubles.
Our outlook for the next quarter
The Australian economy is poised to gain some bit of strength from second-half of 2019 and into 2020. Rate cuts earlier this year, tax relief and recovering housing market should help put a tailwind on the ailing growth trajectory. Latest RBA projections in its August SOMP (Statement on Monetary Policy) forecasts a jump to GDP growth rate of 2.4% in 2H-2019. For this to materialize, we expect RBA to go for at least one more 25 basis point reduction in cash rate this year.
We expect the RBA to step up its communication over how a QE program in Australia might look like. The most likely form would be buying government bonds, which should affect the interest rates across the curve and also put more weakening pressure on the domestic currency. US experience at QE suggests that asset purchases of around 1.5% of GDP are needed to deliver the equivalent of a 25-basis points reduction in official interest rates. A smaller pool of government debt securities in the country might actually translate into a very potent QE program.
We expect AUD to weaken further this year and stabilize around 65 cents to a dollar. This weakening could also be driven by a weak global backdrop and commodity prices. Further rebound in capital city housing prices also looks to be on the cards, fueled by fresh rate cuts. In addition to all of the above, much will depend on how the Chinese economy (the largest trading partner for Australia) responds to International trade developments and broad deleveraging efforts over the next couple of quarters.
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