Australian interest rates August 2015

Rates were left on hold in August ...

As expected the Reserve Bank Board decided to leave the cash rate unchanged at 2.0% following its meeting on Tuesday August 4. However, we were very surprised that in the Governor’s statement on the Australian dollar he did not repeat the sentence “Further depreciation seems both likely and necessary”. It is reasonable that markets will interpret this comment as indicating that the Bank no longer sees further depreciation of the AUD as “likely and necessary”.

... & based on the forecasts ...

This perception has impacted market pricing for both the AUD and the outlook for interest rates. It is reasonable that a key explanation for why markets had been pricing in around a 60% probability of a rate cut by November was the expectation that the Bank would continue to openly discuss the possibility of rate cuts. A key motivation behind cutting rates would be to further lower the AUD. That motivation now seems to have dissipated. Market pricing responded accordingly with the probability of a cut by November now falling to what we consider to be a much more realistic 40%. Appropriately, the AUD has lifted on this re-appraisal, rising to 73½¢ at the time of writing from below 73¢ before the statement.

... that were detailed in the SOMP ...

As we did expect, there are very few additional changes to this statement. The Bank remains confident that inflation will remain consistent with the target over the next one or two years and also notes that the economy is likely to be operating with a degree of spare capacity for some time yet.

... there is no urgency at all ...

In the Bank’s Statement on Monetary Policy, released on Friday August 7, it revised up its May forecast that in 2016 underlying inflation would centre around 2.25%, reverting to the ‘standard’ middle of the 2–3% target band. This is mainly because the forecasts are based on an AUD of 74¢ versus 80¢ in May (notwithstanding a substantially lower oil price assumption).

... to deliver on the modest easing bias ...

We were also interested in the Bank’s forecast of GDP growth in both 2015 and 2016. At this stage of the year the 2015 forecast is of interest in assessing the momentum of the economy moving into 2016; while the 2016 forecast sets the policy agenda. Monetary policy is seen to act with a “long and variable lag” so policy adjustments now can really only be expected to impact the economy in 2016. With the Governor indicating that trend growth, which the Bank has historically assessed as 3% to 3¼%, may be revised down, the Bank’s decision to lower the growth forecast in 2016 from 3¼% to 3% is not as significant for policy than it would be if the trend growth rate had not also been lowered.

... presently in place.

To illustrate that point, if trend growth is assessed as 2¾% then a 3% growth forecast is for ongoing above trend growth. In that circumstance the unemployment rate is likely to be little changed through 2016 before falling in 2017 when growth is forecast to reach 3.75%.

The RBA’s apparent satisfaction ...

Note that last year it became clear by year end that the Bank would not be able to maintain its growth forecast of 3% in 2015 because the economy was losing momentum from a 2.5% growth base through the second half of the year. Once growth was admitted to be likely to fall below trend (3% at the time) then the Bank would have little choice but to ease policy further.

... with current levels of the $A ...

With trend growth lower the Bank would have more scope to retain its current policy of steady rates. The decision to lower the growth forecast for 2016 in the Statement on Monetary Policy has no implications for policy given that growth is still considered to be at or above trend and that is strengthened by its forecast that unemployment will stabilise around current levels in 2016.

... reinforces that assessment.

Despite recent evidence of rapid house price growth in both Sydney and Melbourne there was no elevated concern around the house price issue. Strong price rises were noted in Sydney with the qualification that trends were more varied in other cities. The RBA would be encouraged by commercial banks’ decisions to raise rates on some investor loans; ration loans; and lower selected LVR criteria.

Even so, fixed rates will rise in ‘16 ...

Given that growth in stocks of investor loans reached around 30% in previous periods of strong housing investor markets it is not surprising that the policies being applied are having an impact. We are confident that these policies will significantly slow house price appreciation but not sufficiently to accommodate further rate cuts.

... due to the gravitational pull of the Fed.

While we are confident that the RBA’s cash rate will remain steady over the remainder of this year and that next year fixed rates are likely to be rising. Current pricing point to markets underestimating the pace and timing of the Fed’s rate hike cycle. As markets adjust to the likely reality of a Fed hike in September followed by another move in December, fixed rates are likely to be rising. With the RBA rate holding steady the spread between Australian and US rates will narrow but, nevertheless, Australian fixed rates will also be on the rise due to the strong gravity of the US yield curve.

Bill Evans, Chief Economist

Reproduced from the August 2015 edition of Westpac's market oulook

Past performance is not a reliable indicator of future performance. The forecasts given above are predictive in character. Whilst every effort has been taken to ensure that the assumptions on which the forecasts are based are reasonable, the forecasts may be affected by incorrect assumptions or by known or unknown risks and uncertainties. The results ultimately achieved may differ substantially from these forecasts.

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