It’s now been a year since Philip Lowe took over from Glenn Stevens as governor of the Reserve Bank of Australia (RBA).
Paul Dales, chief Australia and New Zealand economist at Capital Economics, thinks that Lowe has had a solid start to his seven-year tenure as governor (with the exception of a couple of rookie errors on the communications front).
Few will disagree. Yes, there was the infamous discussion on the new neutral level for Australia’s cash rate in the minutes of the board’s July monetary policy meeting, something that caused unnecessary market volatility as traders quickly jumped to the conclusion that the RBA was about to embark on an aggressive tightening cycle, but other than that he’s done pretty well.
Lowe has been crisp in his communication to markets, businesses and households, making it clear than not only does he think the next move in interest rates is likely to be up rather than down, but also that financial stability concerns are now of more importance when it comes to the outlook for interest rates.
Other than that, the economy is performing pretty nicely as we approach the end of 2017.
The labour market has unquestionably strengthened, and business conditions are at the highest levels since before the GFC. Concerns remain around the household sector, particularly when it comes to wage growth and consumption, but it’s still pretty remarkable that the economy is performing as well as it is given the steep decline in mining investment in recent years.
However, 12 months in, Dales says that the true test for Lowe as governor, and the legacy that he will leave when his term ends, still lies ahead, suggesting that the RBA’s economic forecasting, along with managing the risks associated with Australia’s household sector, will determine how the economy looks when Lowe’s tenure ends in late 2023.
On the first challenge, Dales says the RBA’s current optimistic forecasts for GDP growth and inflation are unlikely to come to fruition, something he says will see the bank hold off raising interest rates until 2019 at the earliest.
“The recent momentum is certainly on the RBA’s side, but we believe that a softening in dwellings investment and consumption growth will mean that GDP growth will struggle to top 2.5% in both 2018 and 2019,” says Dales.
“What’s more, we suspect that both cyclical and structural forces will keep wage growth below 2.5%, thereby preventing underlying inflation from rising above 2.0%.”
That’s a similar view to that of Bill Evans, Westpac’s chief economist, who sees GDP growing by only 2.5% next year, ensuring that inflationary pressures remain muted given persistent weakness in household incomes.
In its August statement on monetary policy, the RBA forecast that GDP growth would accelerate to 3% in 2018 before expanding at an even faster pace of 3.25% in 2016. It also saw underlying inflation rising back to the centre of its 2-3% mid-point by the middle of 2019.
As Dales points out, should growth accelerate to those levels, it would mark the fastest back-to-back GDP growth rates Australia has seen since before the global financial crisis.
“Its 2018 and 2019 forecasts imply growth will be faster than in any two years since 2008, when the mining boom was in full flow and before the GFC,” he says.
This chart from Capital Economics shows how its GDP growth forecasts compare to those from the RBA.
Regardless of whether he or the RBA are right on the outlook for GDP or inflation, or somewhere in between, Dales says the other major challenge facing Lowe over the next few years will be how to deliver higher interest rates without causing an even greater slowdown in household consumption or a sharp correction in the housing market.
Such an outcome, and what it would potentially do to the Australian economy, would not deliver the financial stability that Lowe is looking for. Indeed, it would almost certainly create significant financial instability.
Dales sums up the conundrum facing Lowe neatly.
“The idea of higher interest rates probably appeals to Lowe as it would help diminish the risks to financial stability in the medium-term by reducing the incentive to take on more debt. But equally, Lowe knows that raising interest rates will put some heavily indebted households under stress,” he says.
“If interest rates are raised too far too soon over the next couple of years, then it’s possible that the RBA will trigger a sharp fall in house prices and prompt the instability in the financial system that Lowe so desperately wants to avoid.
“So there’s going to be a tricky balance to strike.”
With macroprudential tools seemingly doing their job on that front, and with Australia’s broader economic recovery only in its infancy, it’s debatable whether a series of rate hikes in the near-term would do more harm than good.
That’s something that ANZ’s economics team discussed this week, suggesting that after lifting rates twice next year, the RBA would likely leave policy unchanged for a considerable period given the vulnerabilities that still exist within the household sector.
While Dales doesn’t see the RBA hiking as soon as ANZ, he agrees that when the monetary policy tightening cycle eventually begins, it’s likely to be slow and shallow in nature.
“If we are right and the RBA’s forecasts prove too optimistic, then the RBA may not raise interest rates at all next year. That remains our central view,” says Dales.
“But even if the economy proves to be stronger than we expect, then the high level of household debt means that it makes sense for the RBA to raise interest rates slowly.
“So if the financial markets are going to be wrong, it’s much more likely that it will because interest rates rise later and/or slower than they expect.”
Regardless of what lies ahead, Dales says that how Lowe will be remembered as governor will be determined by what state he leaves Australia’s household sector in.
“If at the end of Lowe’s seven-year term, the household sectors looks less vulnerable, then he will have done a very good job indeed,” he says.
After a solid start, let’s hope Lowe can deliver.