While no one is really sure when it will happen, almost every economist thinks the next move from the Reserve Bank of Australia (RBA) will be to lift official interest rates.
Having reduced the cash rate to its current record-low level of 1.5% back in August 2016, most expect firmer economic growth both in Australia and abroad will eventually help to lift employment, wage growth and inflation, laying the platform for the RBA to begin normalising interest rates.
Some think it’ll be soon, others think it’ll be years.
However, what if everyone is wrong? What if the next move from the RBA isn’t to lift interest rates but to cut them once again?
While it’s not its central expectation, interest rate strategists at Morgan Stanley think such a scenario isn’t too far-fetched, labeling the risk of a rate cut from the RBA as something that may surprise financial markets in the year ahead.
“Against the backdrop of a buoyant labour market in 2017, market pricing as well as economists’ consensus expectations have shifted to expect close to one rate hike by the RBA in 2018,” says Jesper Rooth, Asia ex Japan FX and Interest Rates Strategist at Morgan Stanley.
“Consensus is looking for growth to accelerate further, from 2.3% in 2017 to 2.8% in 2018, while both the unemployment rate and headline CPI are both expected to improve by 0.2 percentage points compared to 2017.
“In contrast, our economists project an unchanged RBA cash rate for 2018 in their base case amid slowing growth and a weaker-than-expected labor market.
“While CPI slowly moves back within the RBA’s target band in 2018, depressed wage growth remains a key concern for the central bank, in particular in an environment of high household debt and declining savings rates.”
Not only are economists at Morgan Stanley unconvinced about the need for higher official interest rates this year, Rooth says there are several factors that could actually see the RBA add, rather than reverse, stimulus to the Australian economy.
At the forefront of these factors is a continued slowdown in wage growth, something that everyone was witness to in late 2017 when it failed to lift by any meaningful degree in the September quarter despite strong employment growth and an unusually large increase in Australia’s minimum wage rate at the start of July.
“Wage growth has averaged lower since the end of the mining boom and has recently failed to pick up despite the improvement in employment,” says Rooth. “Should labor market conditions deteriorate in 2018 — contrary to consensus expectations — this may put further downward pressure on wage growth.”
Although recent strength in Australian building approvals suggests that residential construction may actually add, rather than detract, from economic growth in 2018, Rooth says any labour market weakness will likely to stem from a slowdown in the construction sector.
Along with the risks posed by weak wage growth, Rooth also points to another factor that has recently dominated headlines: the sharp slowdown in Australian house price growth.
“A cool-down in the property market is already visible in some of the major cities,” says Rooth.
“While further price declines are likely to hurt consumption — which stands at around 60% of GDP — via a negative wealth effect, a more meaningful slowdown in construction activity than we currently anticipate would impact the labor market in a very direct way, given the high dependence on the sector.”
According to data from CoreLogic, Australian home prices fell by 0.3% in December, led by declines of 0.9% and 0.2% in Sydney and Melbourne, Australia’s largest and most expensive housing markets.
The monthly decrease, following unchanged readings in October and November, saw annual price growth slow to 4.2%, less than half the pace seen in the first half of the year.
According to CoreLogic’s Australian Head of Research, Tim Lawless, the trends of late 2017 could well be replicated in the year ahead.
“In 2018, the housing market performance is likely to be significantly different relative to previous years,” he says.
“We’re likely to see lower to negative growth rates across previously strong markets, more cautious buyers, and ongoing regulator vigilance of credit standards and investor activity.”
Just how that will impact household consumption, presuming that prices continue to decline, remains anything but certain.
From an international perspective, Rooth says the greatest risks for a rate cut lie with Australia’s largest trading partner, China.
“A sharper-than-expected moderation of growth in China could potentially derail the recovery in Australia through a number of different channels,” he says.
“Among these channels, the commodity link, namely via iron ore, LNG and coal, is perhaps the most prominent one. Prices of key Australian commodities have recovered meaningfully from the 2015/16 lows, representing a boost to Australian terms of trade.”
Along with the risks posed by another terms of trade shock hitting national incomes, Rooth says that from a broader perspective, a slowdown in China “could coincide with a global growth deceleration”.
While Morgan Stanley’s house view is that official interest rates will be left unchanged until at least early 2019, the risks highlighted by Rooth are all plausible, particularly when it comes to intertwined relationship between house prices, labour market conditions and household consumption and their impact on the broader Australian economy.
Most think the slowdown in the housing market will be largely offset by continued strength in labour market conditions, helping to boost wage growth and underpin household spending levels despite the diminished wealth effect on household balance sheets.
However, if that doesn’t take place and house prices continue to weaken, it will undoubtedly raise concern about the outlook for the economy, and raise serious questions about whether higher interest rates are truly required.
No one is really sure how it’ll all play out, even with a noticeable improvement in the economy in the second half of last year.
If any of the factors cited by Rooth do intensify further, it suggests that the risk of a rate cut may well be replicated in reality.