Australian interest rates July 2017

Australian interest rates: on hold 2018 prospects unconducive to hikes.

RBA holds rates steady ...

As expected the Reserve Bank Board held the cash rate steady following its recent meeting on July 4.

Furthermore, despite some market speculation, the Governor issued a Statement which did not contain any hint of a tightening bias. Despite that action, markets have again moved to price in a rate hike of 25 basis points by August next year.

... for the 11th consecutive month ...

This action by the market seems to be in response to firming expectations of policy tightening in overseas markets complemented by the recent buoyant Employment Reports. We have not changed our view that rates will remain on hold throughout the remainder of 2017 and 2018.

... and Governor delivers a neutral statement.

That view is predicated around a number of key forecasts. Firstly, we expect that growth in Australia will slow materially through 2018. Our current forecast of 2.5% GDP growth is in contrast with the Reserve Bank’s current forecast of 3.25% growth in 2018 – an expected lift in the growth momentum from 2017. That 3.25% is around 0.5% above the assessed trend growth rate and is, arguably, consistent with the market’s expectation of a rate hike in 2018. Of course that does not mean that the RBA is committed to a rate hike in 2018. The Bank regularly emphasises the uncertainties around growth forecasts. It has the flexibility to assess the incoming data to determine whether it is consistent with its current growth expectations.

Despite this, markets have priced in a hike for 2018 ...

There are a number of reasons behind our cautious approach to growth next year. Firstly, it seems clear from the dwelling approval data that the housing construction cycle has peaked. We expect that, through 2018, housing construction will be a negative influence on growth subtracting around 0.25% from growth compared to a contribution of 0.3% in 2016.

... taking their cue from offshore markets ...

As we saw in the July Westpac-Melbourne Institute Consumer Sentiment Report, the consumer remains downbeat. Tepid wages growth is the key behind this cautious mood of the consumer. As we are seeing in other countries such as the US; UK; Germany; Japan and New Zealand, even full employment has not been able to boost wages growth. With ample spare capacity set to remain in the Australian labour market, prospects for the recovery in wages growth that has been projected in official circles seems remote. Consequently we expect a below trend contribution to growth in 2018 from consumer spending.

... and official forecasts of above trend growth.

Dwelling construction and consumer spending are key drivers of jobs growth. With both those factors underwhelming we expect spare capacity in the labour market to persist with the unemployment rate edging back to 6% in 2018. Ongoing soft wages growth coupled with further pressures on retail margins are likely to maintain a frustrating undershoot for inflation, with the risk that the Bank’s preferred inflation measures remains below the 2% threshold.

Businesses have been cautious investors through this whole cycle. A downturn in domestic sales growth as consumers and housing activity slow is hardly likely to reboot business investment in 2018.

However, we see growth disappointing in 2018 ...

Finally, the RBA is likely to feel a lot more comfortable about asset markets through 2018. We expect house price inflation to largely disappear over the course of the next year or so – just as we experienced in 2015/2016. That adjustment in 2015/16 was engineered by rising interest rates, which were initiated by the banks in response to tighter official lending guidelines and increased capital requirement. The banks also tightened lending policies.

... keeping the RBA on hold in 2017 and 2018 ...

In that 2015/2016 period the banks raised mortgage rates by an average of 27bps. So far in this cycle rates are up by an average of 28bps although the mix is different. More pressure has been put on to interest only loans (nearly 40% of banks’ mortgage books) with no increases on owner occupied principal and interest loans (compared to 17bps in 2015). As in 2015 banks are also implementing tighter lending policies. It appears that regulators are determined to slow lending particularly for investors (investor interest only loan rates are up by 76bps in the recent months) while commercial property loans are likely to receive attention.

... at 1.50%.

From an interest rate perspective, these conditions we envisage for 2018 would, under other circumstances, look conducive to even lower rates. Indeed I would have to say that if rates do move next year it is more likely to be down than up. However, the experience of the rate cuts in May and August 2016 will not be forgotten by Governor Lowe. As discussed we saw house price inflation come under control by mid-2016 under the weight of the macro prudential tightening. That effect largely dissipated in the wake of those rate cuts. House price inflation returned quickly through the second half of 2016 while the objective of those cuts – to restore underlying inflation to the 2–3% band – was not achieved. That experience, under Lowe’s predecessor, will be vividly recalled.

Bill Evans, Chief Economist.

Reproduced from the July 2017 edition of Westpac market outlook. Business Focus will no longer reproduce this article. You can subscribe to Market Outlook and other economic publications on Westpac IQ and be notified when they are available.

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.