Westpac explains why the RBA will keep rates on hold

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  • Westpac sees Australian economic growth falling below trend this year, placing upward pressure on unemployment and keeping underlying inflation stuck below the RBA’s target.
  • By contrast, the RBA sees growth being above trend, but it expects only gradual progress in lowering unemployment and lifting inflation.
  • Westpac doesn’t see any movement in the RBA cash rate until 2021 at the earliest, although financial markets are starting to price in a reduction towards the end of the year.
  • It says the RBA’s future GDP growth forecasts will determine if, like financial markets, it has a change of heart on the future direction of the cash rate.

Westpac Bank thinks Australian GDP growth will slow to below trend this year, seeing unemployment drift higher and underlying inflation stuck below the Reserve Bank of Australia’s (RBA) 2-3% target.

That’s not what the RBA thinks will happen, at least based upon the forecasts it made back in November, with the bank expecting that strong, above-trend growth will help to place downward pressure on unemployment and upward pressure on inflation, albeit gradually.

If all goes to plan, the RBA still sees the next move in the cash rate as likely to be higher, although not any time soon.

Financial markets don’t agree with that assessment, pricing in a greater than even chance that official interest rates will be cut by the end of this year. A small but increasing number of economists also share this view.

However, despite another year of the RBA failing to achieve its inflation mandate, Westpac doesn’t share that view.

It still sees the RBA cash rate holding steady at 1.5%, and not only this year but until at least the end of 2020.

But why?

If inflation is set to remain sluggish with unemployment moving higher, reflecting that GDP growth is unlikely to grow at potential, then why not join the rate cut club?

Partially it’s because the RBA has not signaled a cut is likely, and until that happens, Westpac will retain its view for another two years of static policy.

“If we thought the RBA was likely to lower its growth forecasts in 2019 and 2020 to 2.5% or less then we would certainly expect it to adopt an easing bias,” says Bill Evans, Chief Economist at Westpac.

However, Evans doesn’t think the bank will do that when it releases its updated economic forecasts in early February, suggesting the RBA is only likely to make modest downward revisions to its GDP growth forecasts based on recent data and recent public statements.

“We expect the RBA will forecast growth of 3% in 2019 and 3% in 2020,” he says, an outcome that would be 25 basis points lower than the central bank’s forecast in November.

“That higher growth [compared to Westpac’s forecasts] will reflect a limited slowdown in housing construction and no meaningful wealth effect,” he says.

“Those growth forecasts are still above trend and likely to ensure the view that the next move in rates will be up.

“Other factors which may impact market thinking are the higher recent levels of BBSW and associated out of cycle hikes by some banks.

“The RBA will probably view those developments as likely to exacerbate housing price weakness but due to an insignificant wealth effect, will unlikely materially change their forecasts.”

Although he disagrees with the RBA that there won’t be any impact from a reduced wealth effect from falling home prices, and thinks the downturn in residential construction will be steeper than the RBA anticipates, until the bank signals that growth will undershoot materially on its prior expectations, it explains why Evans retains his long-held view that policy rates are going nowhere.

Along with the RBA’s next forecasts, released on February 8, Evans says the other area of near-term interest will be whether the bank will adopt a pure neutral bias, indicating that it sees the cash rate holding steady for the foreseeable future.

“The key as to whether the Reserve Bank will placate markets and adopt a pure neutral bias by eliminating the ‘next move up’ in its commentary will hinge on how it reassesses its forecasts,” he says.

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