Top analyst Paul Dales says the 'fragile' housing market is Australia's biggest risk this year

Photo: iStock

While other forecasters are warming to the prospect of a rate hike from the Reserve Bank of Australia (RBA) this year, Paul Dales, Chief Australia and New Zealand Economist at Capital Economics, is not among that group.

Despite recent optimism from the RBA and others, he still sees Australian economic growth languishing in the mid-2% region this year, an outcome that will act to keep inflationary pressures beneath the RBA’s 2-3% target, giving the bank little choice but to leave the official cash rate unchanged at 1.5% for yet another year.

And that could potentially see the Australian dollar fall to as low as 70 US cents, representing a decline of more than 10% from its current level.

“2018 is widely expected to be the year that the Reserve Bank of Australia starts to raise interest rates from their record lows. We disagree,” Dales said in a note released earlier this week.

At the cornerstone of that view is that economic growth is unlikely to accelerate to any significant degree, disappointing those — including the RBA — who are expecting it to increase to an above-trend pace.

“GDP growth in Australia won’t live up to the consensus forecast of 2.9% and the RBA’s 3.0%,” he says.

“GDP growth will still rise from around 2.2% last year to about 2.5% this year, but that would be the eighth year in the past 10 that growth has fallen short of the economy’s potential rate of 2.75-3.0%.”

And with economic growth set to undershoot, Dales says underlying inflationary pressures will yet again fall short of the RBA’s 2-3% target.

Indeed, rather than forecasting that inflationary pressures will build, Dales says they’re likely to do the opposite.

Lower dollar

“The consensus forecast is that underlying inflation will rise from 1.8% now to 2.0% by December and the RBA expects it to stay at 1.8%. We think it will fall to 1.6%,” he says.

“That’s partly due to the downward influence from the introduction of the new spending weights later this month. But it is also based on our view that the spare capacity in the labour market and the influence of long-term global forces will keep wage growth close to 2.0%.”

Given that downbeat assessment, quite a contrarian call to other forecasters out there, Dales says there will be little need for the RBA to consider hiking interest rates.

“Our view that GDP growth and underlying inflation will fall short of the RBA’s expectations suggests that rates won’t rise at all this year,” he says.

“If anything, concerns over how heavily indebted households would cope with higher interest rates provide the RBA with an incentive to keep rates at 1.5% well into 2019.”

Financial markets are close to fully priced for the RBA to deliver a 25 basis point rate increase, taking the cash rate to 1.75%, by December this year.

To Dales, with the RBA set to remain on the sidelines as the US Federal Reserve continues to lift interest rates, the advantage the Australian dollar once enjoyed from higher interest rates will turn to a headwind which, along with weaker iron ore prices and a slowdown in China’s economy, will see it fall to around 70 cents.

“The consensus forecast is for the dollar to weaken to 75 cents this year,” he says.

“But our forecasts that interest rates in the US will rise to almost 1 percentage point above rates in Australia and that an easing in growth in China will contribute to the price of Australia’s iron ore exports falling from $78 a tonne to $55 explain why we believe the dollar could weaken to 70 cents.”

As for the greatest risk to the economy, Dales says it comes from Australia’s housing market, especially should an early federal election be called.

“The biggest downside risk for Australia is the fragile housing market,” he says.

“A surprise Federal election and a victory by the Labor Party would mean that GDP growth in Australia is lower than we expect if Labor curbed negative gearing and the capital gains tax discount on investment properties.

“That may mean interest rates stay at 1.5% for all of 2019.”

As for risks to the upside, he nominates stronger-than-expected growth in China or a faster decline in Australia’s unemployment rate.

“That could lead to faster wage growth and underlying inflation, thereby persuading the RBA to hike rates sooner than we expect.”

That’s something that many other economists expect will take place, creating the platform for the RBA to begin normalising interest rates.

As for who will eventually be proven right — be it Dales or more optimistic forecasters — we won’t know for some time yet.

However, the one thing for certain is that it promises to be an interesting year given the recent divergence between households and other parts of the economy at a time when the housing market is slowing noticeably.

NOW WATCH: Money & Markets videos

Want to read a more in-depth view on the trends influencing Australian business and the global economy? BI / Research is designed to help executives and industry leaders understand the major challenges and opportunities for industry, technology, strategy and the economy in the future. Sign up for free at research.businessinsider.com.au.