The door to another rate cut just opened

Glenn Stevens has just delivered an amazingly frank assessment of where the Australian economy is, where the RBA thought it would be two years and how this combination leaves the governor and his team with the clear view that “as things stand, the economy could do with some more demand growth over the next couple of years”.

That means he has also opened the door to another rate cut, saying there is a “possibility of further policy easing.”

Stevens said recent economic growth has been, “weaker than what, two years ago, we expected would be happening by now”.

Against this though, Stevens said forecasts “are hardly more than educated guesswork” and two-year-ahead forecasts were “even less reliable”.

That’s not to disclaim responsibility for the errors. Rather Stevens said we can learn from these errors. He listed a number of points which were prominent to evaluating what can be learned.

  • The terms of trade, which two years ago were assumed to fall, have in fact fallen further – they are about 12 per cent lower than the assumed path. That means national income is lower, which means spending power is lower.
  • The exchange rate, which at that time was above parity against the US dollar, and was assumed to stay there, is now about 25 per cent lower. It has moved in the same direction as the terms of trade, which is normal.
  • The lower exchange rate has helped to produce a contribution to growth from ‘net exports’ much greater than earlier forecast, while that from domestic demand has been much weaker. The latter is mainly spread across non-mining business investment and weaker government spending, together with softer consumption on account of lower incomes. One thing which is not very different from the forecast from two years ago is that mining sector capital spending is falling sharply.
  • Because the net effect of the above factors is that GDP growth has been on the weaker side of expectations, the unemployment rate is about half a percentage point higher than forecast two years ago. Consistent with that, growth in wages is, as you would expect, lower than forecast.
  • Headline inflation is lower than forecast, largely because of the recent fall in oil prices. Underlying inflation is within the 2–3 per cent range that had been forecast. Again, the depreciation of the exchange rate has been a factor here.
  • The cash rate is 75 basis points lower than assumed two years ago, as monetary policy has used the room provided by contained inflation to try to do more to help growth. Lending rates have fallen on average by about 100 basis points over that period. This has produced a stronger result for housing construction than forecast and will also have contributed to the rise in dwelling prices.
  • This, he said, meant the economy had taken a different track to the one the RBA expected.

    Crucially though, Stevens highlighted that while resource sector investment has a good deal further to fall over the next two years, he has been surprised by the lack of pick-up in other areas of investment.

    I would have expected that by now these would have been showing signs of strengthening; the most recent indications are for, if anything, a weakening over the year ahead.

    Leaving aside the fact that he has explicitly left the door open to further easing, it is this admission which is the clearest signal that the governor has a clear easing bias.

    That’s because it is business investment which remains the missing ingredient in Australia’s economic transition story.

    But Stevens is not overly excited about the prospects for consumers doing much more heavy lifting.

    Looking ahead, the most recent forecasts suggest that growth rates will be similar to those we have observed recently for a while yet. Residential investment will reach new highs over the period ahead. Household consumption is expected to record moderate growth. With national income growth reduced by a falling terms of trade, this requires a modest decline in the saving rate. It doesn’t seem reasonable to expect much more from consumption growth than that.

    Tying it all up, it’s easy to see why the door is ajar for another easing – and the Aussie dollar has dropped half a per cent since he started speaking.

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