As expected, the Reserve Bank Board decided to leave the cash rate unchanged at 1.5%.
Of most interest in the Governor’s statement was going to be the commentary around the recently sharply appreciating Australian Dollar. Recall that since the last Board meeting the AUD has appreciated from USD 0.76 (TWI 65) to USD 0.80 (TWI 67.3). Markets were reasonably speculating that the Governor would attempt to “jawbone” the AUD with comments as potentially extreme as “a depreciation is necessary”. That language was used when the AUD was falling between USD 0.80 and USD 0.75 in 2015.
At the very least there was an expectation that the terminology used by Deputy Governor Debelle in a recent talk: “a lower AUD would be helpful”, would be repeated.
In the event, the Governor took a more realistic approach. The experience of “jawboning” in recent years has been that unless the Bank is prepared to support that sentiment with lower rates, the market tended to ignore it. Consequently, the comment “an appreciating exchange rate would complicate this adjustment” was excluded and it was simply stated that “an appreciating exchange rate would be expected to result in a slower pick-up in economic activity and inflation than currently forecast”.
That statement is supplemented by; “over the next couple of years, the central forecast is for the economy to grow at an annual rate of around 3 per cent”. That compares with the statement in May that “growth is expected to increase gradually over the next couple of years to a little above 3 per cent”. Note that the Bank will release its revised growth and inflation forecasts on August 4 in its Statement on Monetary Policy. In the May forecasts, when the AUD was USD 0.74, growth in 2018 was forecast at 2 ¾ - 3 ¾ per cent, a mid-point of 3 ¼ per cent.
It now seems likely that this growth forecast will be lowered to 2 ½ - 3 ½ per cent.( mid- point of 3 %) That is still a quarter of a per cent above trend growth but does send a more tentative signal about the Bank’s confidence in the growth outlook.
Caution in the growth outlook is also signalled in other parts of the Governor’s statement with a more uncertain view around consumption “one source of uncertainty for the domestic economy is the outlook for consumption”. That compared with the commentary in May of “growth in consumption is expected to remain moderate and broadly in line with incomes”. Further supporting a more cautious approach to the growth outlook is the decision to highlight the expected slowdown in residential construction – something that has not been discussed in recent statements.
The other area of considerable interest around the upcoming forecasts is whether as a result of the much higher exchange rate to be used in the forecasts (recall that at the time of the May forecasts the AUD was USD 0.74 and TWI 64), the forecast for underlying inflation which currently stands at 1 ½ - 2 ½ per cent (mid-point of 2 per cent, the bottom of the target zone) will be lowered. That would be a most unfortunate development from the perspective of the Bank’s credibility and is unlikely to happen despite the commentary around “the appreciating exchange rate”.
In previous Board minutes, it has been emphasised that the labour market and the housing market are the key areas of interest for the Bank. (With the recent appreciation of the currency, the AUD must be added to that list).
The commentary around the labour market is still somewhat cautious despite consistently strong employment numbers. That is because concerns around wages growth remain, with the damaging feedback loop from low wages growth to weak consumption and business investment being of paramount concern.
Despite some very recent reports that housing markets particularly in Melbourne may be heating up again, probably supported by generous state government subsidies to first home buyers, the Governor chooses to repeat the commentary in July that “there are some signs that these conditions are starting to ease”.
On the international front, the Bank remains cautious around China. It accepts that growth has “picked up a little” but still highlights the high debt levels presenting medium term risks.
In that regard, the Governor has chanced his arm at forecasting commodity prices by noting “commodity prices have generally risen recently, although Australia’s terms of trade are still expected to decline over the period ahead”. He also sounds a note of confidence that the Federal Reserve will continue raising rates - “Federal Reserve expects to increase rates further”.
Those two points combined imply that the Bank is anticipating a lower Australian Dollar, however it has consistently maintained the methodology of assuming that the current level of the Australian Dollar will hold for the full forecast period, which will now be out to the end of 2019.
Despite the Governor stating “the Bank’s forecasts for the Australian economy are largely unchanged”, it appears clear to us that it will revise down its growth forecast for 2018 from 3 ¼ to 3 per cent in response to the rise in the AUD. That number is still well in excess of our own forecast of 2 ½ per cent. We have arrived at that number despite our underlying assumption that the AUD will fall to USD 0.65 by the end of 2018. If we were forced to use an AUD of USD 0.80, we would see the need to further lower our growth forecast.
I am a little surprised that the Bank is likely to take this step given generally positive developments around the world economy, the labour market and business confidence since May. It would have been strategically tempting to maintain the 3 ¼ per cent forecast despite the higher AUD and the accepted forecasted methodology.
This does emphasise how concerned the Bank is likely to have become with the recently stronger Australian Dollar.
Until now, we were clearly of the view that with the expectation that growth would reach 3 ¼ per cent in 2018, the Bank was expecting that rates would need to be increased some time in that year. Whilst aware of that, we maintained our view that rates would remain on hold in 2018 given that as 2018 developed,we expected that the Bank would accept that growth was likely to remain below trend precluding the need to raise rates.
We remain comfortable with our on hold call, and can only conclude from the Governor’s statement that the Bank is not as resigned to a rate hike in 2018 as may have been the case a month ago.
BILL EVANS is chief economist of Westpac.