RBA wrong to rely on small wealth effect given ongoing falls in house prices: Bill Evans

EXPERT OBSERVER

The Reserve Bank has released its November Statement on Monetary Policy and a major interest is always in any revisions to its output, employment and inflation forecasts.

In that regard, we were a little surprised that the forecast for growth in 2019 remained at 3 ¼ per cent. That is because in the Governor’s Decision Statement following the November Board meeting, he noted “the forecast for economic growth in 2018 and 2019 have been revised up a little."

The central scenario is for GDP growth to average around 3 ½ per cent over these two years”. That seemed to point to an upward revision for the 2019 forecast but instead it remains 3 ¼ per cent.

However, there is some recognition of stronger growth in the second half of 2019 since growth through to June 2020 has been revised up from 3 to 3 ¼ per cent.

It is true however, that growth in 2018 has been revised up to 3 ½ per cent from 3 ¼ per cent, although that largely reflects a higher starting point given that the previous estimate of growth to June 2018 was lifted from 3 per cent to 3.4% actual.

The forecast for 2019, nevertheless, is significantly higher than Westpac’s forecast of 2.7%.

This can largely be explained by an assessment by the RBA that there will be no marked reduction in residential construction activity in 2019 and limited reduction in 2020. Secondly, the assumption is that household consumption growth will be sustained at around the current 3 per cent pace over the forecast period.

With regards to the residential construction cycle, the assumption is that the fall in building approvals, which is already apparent and the information the RBA has received from its liaison contacts in the industry that off-the-plan sales have slowed significantly, will not significantly impact activity until beyond 2020.

This seems to overlook evidence of a clear slowdown in non high-rise approvals, the likelihood of an increase in abandonments of approvals which are already in the system, and evidence, which the RBA notes, that “lot sales for new detached housing have also declined sharply in Sydney and Melbourne since late 2017”.

Instead we assess that all of these forces point to a more significant reduction in dwelling construction in 2019 and 2020 than the RBA is expecting.

The view around consumption growth being sustained at 3 per cent looks courageous. It relies on ongoing growth in employment despite a clear slowing through 2018, the elusive pick-up in wages growth, and only a relatively small wealth effect that might be related to the ongoing falls in house prices and associated household wealth. We would expect that with the savings rate down at around 4 per cent, this wealth effect is likely to be more significant.

There has also been an increase in the forecast for underlying inflation for the year to December 2019 from 2 per cent in the August SoMP to 2 ¼ per cent. With the recent September quarter inflation report confirming that underlying inflation is running at 1 ¾ per cent, this forecast lift of ½ per cent in underlying inflation looks to be optimistic.

The justification behind this increase is around expected faster wages growth and a larger reduction in the output gap due to the above trend growth in 2018 and 2019.

The history of underlying inflation indicates that a ½ per cent jump over the course of one year seems optimistic given the correction in housing that is underway.

The RBA’s analysis of the prospects for wages growth is tentative. In fact, it points out that “wage outcomes from enterprise bargaining agreements are likely to remain a drag on overall wages growth” and also points to its liaison work which notes that “there is still spare capacity in the labour market”.

Appropriately, the SoMP spends some time referring to international evidence which indicates that Australia’s unemployment rate could fall well below historical estimates of the NAIRU “before there is a material increase in wages growth”.

This evidence refers to globalisation, technological change, and changes in relative bargaining power. Other major risks to this inflation forecast relate to ongoing competitive forces in the retail sector and “a risk of further declines in administered prices” due to government initiatives to reduce cost of living pressures.

As was indicated in the Governor’s Decision Statement, the forecast for the unemployment rate has been lowered. However, this appears to be a cautious ‘mark-to-market’ exercise.

In August, the forecast was for the unemployment rate to fall from 5 ½ per cent in December 2018 to 5 per cent by December 2020.

The new forecast is for the unemployment rate to fall from 5 per cent in December 2018 (recognising the most recent employment report) to 4 ¾ per cent in December 2020.

The discussion around the risks of a lower NAIRU would suggest only a very limited prospect of resurgent wage pressures should the unemployment rate only fall by a ¼ per cent in two years.

It is difficult for a central bank to acknowledge political risks but with a Federal election certain to be called in 2019, the uncertainty/ confidence factor associated with such an event might also have been incorporated in the forecasts.

But their assumption around employment growth, income growth and business investment seems to indicate no effect taken into account – both construction activity and machinery and equipment investment are expected to be boosted.

Conclusion

On face value, the stronger growth and higher inflation forecasts might imply that the RBA is closer to raising rates than we have expected. That may well be the case from their perspective. But if the economy evolves as we expect with a slowdown in consumer spending, a contraction in residential investment, and softer confidence partly linked to global uncertainty, the RBA’s growth and inflation forecasts are unlikely to be achieved.

Of course, it will take some time for these developments to be apparent and based on the Governor’s comment “the Board does not see a strong case to adjust the cash rate in the near-term”, we have ample time for the outlook to evolve without a surprise policy adjustment based on these forecasts.

Westpac confirms its view that the cash rate will remain on hold through 2018, 2019 and 2020.  

BILL EVANS is chief economist of Westpac.