Australian interest rates September 2015

The Q2 GDP report, while weak ...

This week’s GDP report was undoubtedly weak, with annual growth slowing from 2.3% to 2%. However, strong growth in tourism services means the impact of exports on employment is stronger than if export growth was concentrated in resources. This effect may partly explain why employment growth has held around 2% despite below-trend GDP growth of only 2%. Until recently, the Reserve Bank assessed that trend growth of 3% was needed to deliver the 1.5%–1.75% growth in employment required to stabilise the unemployment rate.

... is not enough on its own ...

The question is whether this disappointing result will be enough to move the Reserve Bank to cut rates further by the end of this year. Note that markets are pricing in a near 100% probability of a 25bps rate cut by December.

... to sway the RBA ...

We do have a recent precedent for a weak GDP read prompting the RBA into action. Recall that following the release of the September quarter national accounts on December 3 2014, Westpac changed its rate call to expect two further cuts, beginning in February 2015. That came as a surprise to markets and economists, with no other forecaster calling for two moves with the first one as early as February.

... from its current stance.

That call was based on the poor results in the 2014Q3 GDP report. In that report, GDP growth printed 0.3% (compared to 0.2% for the 2015Q2 print), and six-month annualised GDP growth fell from 3% to 1.6%. The economy was clearly losing momentum and it was not going to be credible for the RBA to stick with its 3% growth forecast in 2015 when it next updated its forecasts in February 2015.

The lift in net services trade …

At that time, the Bank was focussed on the economy needing to achieve trend GDP growth to stabilise the drift in the unemployment rate. It believed that trend growth was 3% and the collapse in momentum that was apparent in the September quarter national accounts made it unlikely that it could credibly persist with a 3% forecast for 2015. Some action would need to be taken to help boost the growth forecast.

... is helping the labour market ...

Nine months on and the Bank now appears to have lowered its estimate of trend growth to 2.75%. Further, we have observed over the past year that 2% employment growth has been achieved, despite GDP growth of only 2%.

... ‘outperform’ total GDP growth.

The key explanation is that export growth (which has contributed nearly half [0.9ppts] of the 2% growth) has become more “jobs intensive” due to the switch towards the job sensitive services sector and away from resources. This is a direct result of the sharp fall in the AUD, making Australia’s services exports much more competitive. The AUD/USD has fallen from 93¢ to around 69/70¢ over the last 12 months.

Whilst the RBA feels it can ...

In fact, despite the Bank only forecasting GDP growth of 2.5% in the year to June 2016, it has revised its unemployment forecast, now expecting that the unemployment rate has peaked. So the attitude of the monetary authorities to the all–important labour market has changed significantly, from worrying about the need to reboot growth to 3% (in December last year) to recognising that the “jobs intensity” of our exports has changed, due to the increasingly competitive AUD. Hence, the unemployment rate can stabilise at a lower GDP growth rate.

... maintain stability ...

With the considerably lagged effect of the falling AUD still to further boost net services exports, the Bank is likely to maintain that confident view for some time – I think it would certainly be resilient to some short-term volatility in the monthly employment reports. On this point, the upcoming August employment release will incorporate revisions based on a lower population trajectory, which creates more than the usual uncertainty around the headline numbers.

... in the unemployment rate ...

That thinking, however, does not preclude the Bank from eventually seeing the need for lower rates. The persistence of the 2% to 2.5% GDP growth prints has coincided with sub-2% nominal income growth, associated with consecutive years of 10% falls in the terms of trade (despite the falling AUD). If we were to assume another 10% fall in the terms of trade in 2016, which would most likely lead to another 2% growth year, then the recent strong employment growth might be sorely tested.

... it will be loath to move.

For our part, our central case is for stability in the terms of trade in 2016, associated with 2.75% real GDP growth, a rising share of job friendly services exports and a modest downward trajectory in the unemployment rate. On that basis, we retain our call that rates will be on hold for the remainder of this year and 2016, but we will continue to stress test our commodity views with the state of China’s construction cycle; global growth in general; and the production plans of the major iron ore and coal producers being centre stage.

Bill Evans, Chief Economist

Reproduced from the September 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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