Benign inflation number will result in no cash rate jump: Bill Evans
EXPERT OBSERVER
The minutes of the Reserve Bank’s Board meeting on April 3 contained a surprise in the final paragraph – “it was more likely that the next move in the cash rate would be up, rather than down”.
We have seen the Governor make that statement in speeches but have not previously seen a formal confirmation from the Board.
The timing is particularly pertinent given developments around financial conditions; the jobs market; and a looming Inflation Report.
Think back to April 2016. Markets were relatively benign with one cut priced in over the next 12 months. Today markets are priced for one hike by mid-2019.
Then we saw the March 2016 Inflation Report. Markets were expecting a rise of 0.5% in the underlying inflation measures while our analysis of the RBA’s forecasts suggests it was expecting 0.6%.
In the event the underlying CPI measures printed an average of 0.175%. The Board had been forecasting 2.5% for annual underlying inflation for 2016. On the basis of that March Report the forecast was lowered to 1.5% and the Bank cut the cash rate by 0.25% in both May and August 2016.
On April 24 there will be another Inflation Report, this time for the March quarter 2018. Westpac (and the market) is once again forecasting 0.5% for the average of the underlying measures. This time, however, the Bank is forecasting 1.75% for 2018 implying an average of around 0.45% for each quarter.
What caused the big surprise in 2016?
“House purchase” (the cost of building a home) rose by only 0.2% whereas we expect 0.7% (following 0.6% last quarter) for March 2018.
Most of the demand related components were lower in 2016 than we expect in 2018.
Clothing and footwear (–2.6% in 2016; –2.0% in 2018); household contents (–0.4%; –0.3%); communication (–1.5%; -0.9%); audio visual (–3.5%;-2.2%); holiday travel (–2.0%; –0.2%) are all expected to be less negative in 2018 than 2016 but nevertheless signalling deflationary forces.
We also expect the large seasonal components pharmaceuticals (4.8% in 2016; 5.3% in 2018) and education (3.1% in 2016; 3.8% in 2018), to be higher in 2018.
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Finally there was a 10% fall in fuel prices in 2016 whereas they have been steady in 2018. This component would have been “trimmed out” of the 2016 numbers although there would have been some indirect effects through business costs that may have further biased down the 2016 numbers.
So we can reasonably conclude that the housing weakness and strong deflationary effects we saw in 2016 are unlikely to be replicated in the same size in 2018 dismissing the prospects of
a 2016 style shock. Nevertheless the themes remain the same – weakening housing and deflation in demand related components precluding us from entirely dismissing a repeat of the 2016 episode.
Further, I don’t expect that Governor Lowe would respond to such a shock in the way we saw with Governor Stevens. True, both were or are observing a rapidly cooling housing market.
In March 2016 Sydney house prices had fallen 4.2% (six month annualised) compared with an increase of 18% a year earlier.
In Melbourne prices were up by 2.8% compared to 21% a year earlier.
Today the numbers are Sydney (–5.4%; 21%) and Melbourne (2%; 16%). Note the second boom in house prices in both Sydney (21%) and Melbourne (16%) followed the 2016 rate cuts.
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Governor Lowe has the benefit of observing that the Stevens’ rate cuts achieved little in restoring inflation pressures (note we are still experiencing deflationary pressures in the demand related components of the CPI) while the cuts did reignite the housing market requiring another round of macroprudential policies.
However Governor Lowe is now facing a significant tightening in financial conditions, partly emanating from offshore, that was not apparent for Governor Stevens.
The Bank Bill Swap Rate which determines funding costs for most corporates and commercial borrowers has lifted by around 30 basis points - spreads against the risk free rate are now the widest since 2009.
This rate also drives the wholesale funding costs of banks and non- banks.
Various explanations have been put forward to explain this development. It appears to be the unfortunate coincidence of a number of factors which are impacting both the demand and supply of US money market instruments. On the supply side the US Treasury has sharply lifted its issuance of short term assets to fund the lifting of the debt ceiling and the fiscal stimulus.
On the demand side we have seen the US Federal Reserve begin to shrink its balance sheet after years of quantitative easing while US corporates who had accumulated vast quantities of short term paper investments are now eschewing those investments in favour of very short term liquidity in anticipation of managements’ decisions on the use of this liquidity.
This flexibility comes in response to tax changes announced in the recent overhaul of tax arrangements which has freed up these liquid investments. In addition, the BEAT tax has encouraged US branches of foreign banks to replace inter-office loans with direct wholesale funding.
These forces have boosted the LIBOR rate which has fed directly into the BBSW rate as Australian banks convert more expensive US funding to AUD or switch demand back to the domestic markets.
While conditions for business borrowers have tightened, banks have not adjusted their standard variable mortgage rates therefore moderating the impact on the economy of these higher rates.
However, banks must be experiencing some pressure. This would be despite the fact that banks have raised their retail deposit shares of funding from around 50% pre GFC to around 60%.
At least one mortgage lender has raised its mortgage rates (another bank Suncorp raised rates by 5bps). Members Equity
Bank has raised its owner occupier principal & interest (P&I) rates by 6 bps; Investor P&I by 11 bps; and investor interest-only loans
by 16 bps. This entity would not have the extensive access to retail deposits that we see for the banks and would therefore most likely be disproportionately affected by the increase in wholesale rates. ME Bank also attributed the rate hike to increased compliance costs associated with the regulator.
These policy moves from the regulator can also be expected to tighten financial conditions over the medium term. The Reserve Bank’s Financial Stability Review notes that, according to their estimates, directions to move borrowers from interest only loans to principle and interest may have implications for households’ disposable incomes.
Around 30% of the current stock of mortgage credit is expected to move from IO to P&I over the next 4 years. The step up in mortgage payments when the IO period ends is estimated to be in the range of 30 to 40 per cent even after factoring in the typically lower interest rates charged on P&I loans.
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This constant pressure on the household balance sheet can, arguably, lower the “neutral” interest rate over that period. Currently the Reserve Bank estimates it as a cash rate of 3.5%.
Finally it would be remiss not to point out further confirmation of our view that the growth pace of the labour market would ease significantly in 2018. Recall that employment growth over 2017 has been around 3.4% while the momentum in the first three months of 2018 has slowed to 1.2%. We remain comfortable with an expectation of around 2% employment growth in 2018 – a pace likely to hold the unemployment steady around 5.5%.
In conclusion we do not see the decision by the Board to speculate that rates have bottomed out as significant. The basic trends in inflation remain in place along the lines of what we saw in 2016. In such an environment there will always be a chance of a much lower Inflation Report on April 24 than we are expecting (recall 2016). However, until recently, the hurdle for lower rates has been much higher than 2016.
In 2016, we did not experience this bout of tightening financial conditions either through rising funding costs or regulation. Combine that with a slowing housing and jobs markets and if anything, the Board’s declaration does look a little bold.
Westpac remains very comfortable with its out of market call for the cash rate to remain on hold in 2018 and 2019.
BILL EVANS is chief economist of Westpac.
