Why the RBA will make another cut

As expected the Reserve Bank of Australia (RBA) cut interest rates by 25 basis points on Tuesday, taking the cash rate to 1.25%. We take a look at the economic indicators in conjunction with Governor Lowe’s comments to help determine what the most likely action is for the RBA. Given the deterioration in economic data and the remark that it would not be “unreasonable to expect a lower cash rate” from here, we believe that the RBA will follow up with a second interest rate cut before pausing to survey its effects.

Why did the RBA cut - what’s changed?

Over the past three years the RBA has kept the cash rate on hold despite missing its inflation target over almost all of this period. Because of this, it is important to first understand why the RBA decided to cut interest rates now. Governor Lowe actually tackled this question directly in his recent speech, making the comment that the data has evolved which allowed them to reach two new conclusions:

“The first is that inflation pressures are subdued and they are likely to remain so. And the second, and related conclusion, is that there is still significant spare capacity in the Australian labour market.”

This statement tells us that not only is inflation expected to remain low for some time, but in order to rectify that, the RBA is going to need to reach a lower unemployment rate than it previously expected. We look at each factor below.

Employment

The first reason to tackle is employment, which had been exceptionally strong during 2018 but has since begun to show some signs of slowing. Despite these signs of slowing, this is not the reason that the RBA has become more dovish. Rather, it now notes that the level of “full employment” (i.e. an unemployment rate which does not substantially increase inflation) is below 5%.

“For some years, most estimates of full employment, including our own, equated to an unemployment rate of around 5 per cent… But, given the combination of the labour market and inflation outcomes we have seen of late, our judgement now is that we can do better than this – that we can sustain an unemployment rate of 4 point something.”

This statement tells us that the RBA believes it can push the unemployment rate lower than previously expected, without causing high levels of inflation. Looking at the unemployment rate over the past 10 years shows that wages have been very slow to react to the improving labour market, with wages growth still below the levels that they fell to during the Global Financial Crisis. Given the level of full employment is unobservable (i.e. it can only be estimated), then the current weak wages backdrop gives the RBA the ability to ease policy without worrying about inflationary pressures.

Chart 1 - Australian unemployment and wages

Source: Bloomberg

Disaggregating the state employment data would confirm the RBA’s decision to revise down their full employment estimate. Even the states that are achieving sub 4% unemployment are not achieving high levels of wages growth. For example, the ACT has an unemployment rate of 3.8%, but wages growth of only 2.1%. Looking across the state unemployment rates against wages shows no signs of pressure, regardless of the level of unemployment, and points to the fact that the RBA is further away from full employment than it had hoped.

Table 1 - State and Territory unemployment rate and wages growth

Stepping back from this spare capacity and wages argument, it is also worthwhile pointing out that the forward indicators for employment present a far more mixed signal than the RBA currently describes. Despite producing almost 100 thousand full time jobs over the past six months, the most recent unemployment print saw unemployment rise to 5.2%, taking some shine off the labour market.Source: Bloomberg, Australian Bureau of Statistics

Chart 2 - Full time job creation and unemployment

Source Bloomberg

This, by itself, should not be enough to knock the RBA off course, as the unemployment rate can be a volatile series and an increase of 0.1% is not considered a change in trend. However, it wasn’t just the headline unemployment rate which rose, but rather multiple lead indicators have declined over the past two months. The May Statement of Monetary Policy refers to Job Vacancies, Job Ads and NAB Employment Conditions as statistics that the RBA watches as forward indicators. Since May 2019, both Job Ads and NAB Employment Conditions have declined, pointing towards a deteriorating employment outlook compared to three months ago.

Charts 3 - Job ads and vacancies (YoY)

Source: Bloomberg

Chart 4 - Job ads and vacancies

Source: Bloomberg

On top of this, the Australian Institute of Geoscientists (AIG) employment surveys have also been declining, similar to the NAB employment index, with the construction series particularly weak. This suggests that the weakness seen in the NAB Employment Outlook is not just a discrepancy, but is rather a larger trend seen across different business surveys.

Chart 5 - Business surveys employment conditions

Source: Bloomberg

Overall, this tells us that not only has full employment been revised down by the RBA, but the employment outlook is not as positive as it was six months ago. Given there are no signs of inflation and GDP has printed at its slowest level since 2009, this has allowed the RBA to move to a more dovish stance as the evidence is pointing to a slowing economy rather than one that is overheating.

Inflation

The second area that the RBA has re-accessed is their inflation expectation, now seeing inflation as slower to recover than previously expected. Governor Lowe made the following comments on inflation:

“The subdued inflation pressures reflect a number of factors. These include slow growth in wages, increased competition in retailing, the adjustment in the housing market… and various government initiatives to reduce the cost of living pressures on households. These factors are all putting downward pressure on prices and they are likely to remain with us for some time yet.”

Given the RBA has missed their headline inflation target for almost five years now, this assessment should not come as a surprise and reflects a sober assessment of the current inflation environment. Since early 2018, inflation has actually slowed with headline inflation at 1.3% and core inflation at 1.4%.

Chart 6 - Australian inflation rate

Source: Bloomberg

As we pointed out earlier this year, the biggest challenge for the RBA comes from housing inflation and there is little reason to expect this to improve as long as house prices are declining. When looking at domestic inflation (non-tradeable inflation), which makes up 60% of total inflation, there has been a very strong relationship between housing CPI and domestic prices. This means that as long as the housing situation continues to deteriorate, there will be a diminished ability for the domestic economy to produce inflation.

Chart 7 - Housing inflation and non-tradable inflation

Source: Bloomberg

The RBA has finally noted this problem in their recent May Statement of Monetary Policy, pointing out that both rents and new dwelling costs have been slowing and that this will cause a drag on inflation:

“The two largest housing components of the Consumer Price Index (CPI) basket are rents and new dwelling purchases by owner-occupiers… Over the past year these two components have been much weaker than average and have contributed notably less to CPI inflation.”

“Weaker conditions in the housing market have exerted downward pressure on inflation.”

In addition to housing, when we look more broadly at inflation there are very few signs of prices becoming inflationary. For example, as mentioned above, core inflation is running in the mid-single digits and if we look at inflation excluding tobacco prices, then headline inflation would actually be closer to 0.8%. Given tobacco only makes up 3% of the inflation basket, and is seeing price increases because of government tax increases, it means there are very few price pressures currently in the economy.

Chart 8 - Inflation ex tobacco

Source: Bloomberg, Nikko AM

Looking more broadly across the sub-indices, only four sectors currently have inflation above 2%, with the only category that looks to be truly inflationary being Alcohol and Tobacco at 6.4%. Comparing this to the inflation breakdown of December 2013, when inflation was squarely in the 2 – 3% band, there were far more consistent price increases with four sectors above 4%.

Chart 9 - Australian CPI components

Source: Bloomberg

Overall, this points to very few inflationary pressures in the Australian economy, consistent with what the RBA is describing. In order to get towards their 2 – 3% inflation target, it will need to provide further stimulus. Given housing inflation has been the problem, an improvement in house prices would obviously be positive. While many in the market think that interest rate cuts have done nothing for inflation, the timing between rate moves and housing CPI (in 2016 in particular) would imply that further easing should help the situation.

Chart 10 - Housing inflation and rate cuts

Source: Bloomberg

Growth

The final point to make here is that the interest rate cut in June does not mean the RBA thinks the economic outlook is deteriorating. Lowe explicitly made the point that this was not the case in his recent speech:

“I want to emphasise that the decision is not in response to a deterioration in our economic outlook since the previous update was published in early May… The Australian economy is still expected to strengthen later this year.”

Despite this comment, the economic situation has clearly deteriorated since late last year and GDP growth has declined to 10-year lows. While GDP was not released until a day after the RBA meeting, this outcome was in-line with their May forecast of approximately 1.75%.

Chart 11 - Australian real GDP

Source: Bloomberg

Looking at GDP growth from the household and government sectors shows large divergences between sectors. Household consumption has slowed to 1.8% year-on-year, while the government sector is growing at over 5%. Add to this the fact that dwelling investment declined 3.1% year-on-year and it becomes clear that households could use some support from the RBA.

Chart 12 - GDP figures - Consumption

Source: Bloomberg

There are also clear risks rising in China, with a particular emphasis on the trade war between China and the US potentially becoming more aggressive than the market previously thought. Lowe mentioned this risk briefly in his speech, but it was also acknowledged in the Statement of Monetary policy:

“The economic outlook remains reasonable, with the main downside risk being the international trade disputes, which have intensified recently.”

“Global growth moderated in the second half of 2018 and looks to have continued at a similar pace into 2019. The moderation was partly driven by a sharp slowing in global trade, related to slower domestic demand in China and a turn in the cycle in the global electronics industry,”

This could reflect the idea that while the RBA knew about a slowing housing market and low inflation, adding on top the risk of declining Chinese trade was enough to tip them into easing rates. The chart below from the Statement of Monetary Policy on global trade shows just how quickly the global trade situation turned.

Chart 13 - World merchandise import volumes growth (smoothed, year-ended with contributions)

Source: Statement on Monetary Policy, May 2019 Reserve Bank of Australia (data from CEIC Data, CPB Netherlands, RBA)

While the RBA is describing a relatively positive growth outlook, this has clearly deteriorated from late last year and brings with it new risks should the trade war intensify.

What to expect

Given the outlook for employment and inflation has deteriorated over the past few months, we believe that the RBA will follow up this cut with a second later this year. The fact that the RBA is still describing a relatively positive growth outlook and went out of their way to describe the cut as being the result, in part, of a fall in their estimate of full employment, we think the RBA is likely to pause after the second cut to survey its effects. Should the economic situation deteriorate, the RBA would likely want to move again, but that is not a forgone conclusion and it will likely want to see more economic data before it makes that decision. This would be in-line with the interest rate cuts of 2015 and 2016.

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