There are still a lot of hurdles to clear before the RBA can look seriously at lifting rates

Photo: Martin Bernetti / AFP /Getty Images

The Australian economy is looking in good shape.

Lead indicators such as business confidence, job ads and PMI reports have been strengthening for some time, and now hard data such as employment growth and retail sales appear to be following suit.

Throw in strengthening global activity levels, as seen in China’s Q2 GDP report this week, you can see why financial markets and analysts are getting excited about prospects for the Australian economy.

The Australian dollar has been on a tear since early May, jumping by 8% against the US dollar, leaving at its highest level since May 2015. It’s also performed well on a trade-weighted basis, hitting its highest level since March, according to the Reserve Bank of Australia (RBA).

Commodity prices are also rebounding, adding to confidence among some market participants that the RBA will soon follow in the footsteps of other major central banks and begin to hike official interest rates.

And look what the RBA had to say on the Australian economy in the minutes of its July monetary policy meeting:

Domestically, the data available for the June quarter had generally been positive, following the slower growth recorded for the March quarter. Although recent indicators suggested that consumption growth had increased in the June quarter, members noted that there were still risks to consumption growth should household income growth remain subdued, particularly given the high levels of household debt. Against this background, the recent improvement in labour market data had been a positive development. Members noted that the strength of recent labour market data had removed some of the downside risk in the Bank’s forecast of wage growth.

Business surveys had continued to suggest that business conditions were above average. Recent state budgets and data on non-residential construction suggested that the contribution to growth from infrastructure investment would rise. The pipeline of residential construction was expected to support dwelling investment over the forecast period. The economic outlook continued to be supported by the low level of interest rates.

And, continuing with that positive theme, here’s what it had to say on current labour market conditions:

Recent data had provided further confirmation that labour market conditions had improved since late 2016, consistent with signals from forward-looking indicators in previous months. Employment growth had been strong in May for the third consecutive month. Members noted that growth in the preceding few months had been driven entirely by full-time employment and that total hours worked had trended higher as a result. The unemployment rate had declined by 0.3 percentage points over the previous two months, to be at its lowest rate since early 2013.

Forward-looking indicators of labour demand, such as job advertisements and business hiring intentions, had remained positive and generally consistent with the patterns of employment across states and industries.

There’s certainly a lot more confidence here than the view the RBA held just a few months ago, and an assessment that has some excited about the prospect of an interest rate hike arriving within the next 12 months, especially given the RBA is already forecasting economic growth and inflationary pressures will continue to build.

However, while confidence towards the economic outlook is firming among some, Bill Evans, Westpac’s chief economist, remains unconvinced. He suggests a decline in Australian dwelling construction, along with continued weakness in consumer spending, will see growth undershoot ever-growing expectations over the next 18 months.

“There are a number of reasons behind our cautious approach to growth next year,” he says

“Firstly, it seems clear from the dwelling approval data that the housing construction cycle has peaked. We expect that, through 2018, housing construction will be a negative influence on growth subtracting around 0.25% from growth compared to a contribution of 0.3% in 2016.”

Secondly, he thinks a rebound in household consumption, the largest part of the Australian economy, is unlikely to materialise, noting that consumer confidence “remains downbeat” due to “tepid wage growth”.

“With ample spare capacity set to remain in the Australian labour market, our prospects for the recovery in wages growth that has been projected in official circles seem remote,” Evans says. “Consequently we expect a below trend contribution to growth in 2018 from consumer spending.”

If Evans is on the money, that will present a problem given retail and residential construction are some of the largest employing sectors in the country (sitting just behind healthcare at second and third respectively).


Source: JP Morgan

How they perform will have a large bearing on labour market conditions and, as by-products, inflationary pressures and economic growth.

Evans says the outlook remains “underwhelming”.

He expects “spare capacity in the labour market to persist with the unemployment rate edging back to 6% in 2018”.

“Ongoing soft wages growth coupled with further pressures on retail margins are likely to maintain a frustrating undershoot for inflation with the risk that the Bank’s preferred inflation measures remain below the 2% threshold.”

Unemployment with a six-handle, leading to elevated levels of labour market slack, would — in all likelihood —
lead to continued softness in wage and inflationary pressures, a scenario that few will disagree will create headwinds for household spending, especially with Westpac forecasting that house price growth will “largely disappear over the course of the next year or so”.

It doesn’t stop there.

That expected slowdown in consumer spending will flow through to business investment, says Evans, creating further downside risks on the outlook for economic growth.

“A downturn in domestic sales growth as consumers and housing activity slow is hardly likely to reboot business investment in 2018,” he says.

While this is only Evans’ assessment, he’s not alone in casting doubt over a pickup in economic activity in the years ahead.

“It is not hard to see a circumstance in which the Australian consumer comes under more pressure”, said JP Morgan economists in June. “If the labour market eventually buckles under these twin pressures (weak conditions in retail and residential construction), then the RBA may be facing a more acute collapse in employment growth and consumption.”

Alan Oster, chief economist at the National Australia Bank (NAB), has a similarly cautious view.

“The longer-term outlook could easily underperform the RBA’s upbeat expectations as important growth drivers (such as) LNG exports, commodity prices and housing construction begin to fade,” he said following the release of the NAB’s June business confidence survey.

“Given the risks to the outlook, signs of moderation in the housing market, and a reluctance to see the AUD strengthen further, the RBA should be content with keeping interest rates on hold for an extended period.”

They’re all very similar assessments and, like Oster, Evans questions whether such a scenario warrants higher interest rates.

“From an interest rate perspective these conditions we envisage for 2018 would, under other circumstances, look conducive to even lower rates. Indeed I would have to say that if rates do move next year it is more likely to be down than up,” he says.

While that’s not what he’s expecting, forecasting that the cash rate will remain unchanged until at least the end of 2018, it’s a very different view to other commentators, and indeed financial markets, who are starting to price in a rate hike, potentially even within the next few months.

Expectations for higher interest rates went into overdrive yesterday following the release of the minutes of the RBA’s July monetary policy meeting where it discussed Australia’s new neutral policy level, now deemed to be 3.5%.

“All estimates of the neutral real interest rate for Australia suggested that monetary policy had been clearly expansionary for the preceding five years or so,” the minutes read.

With the cash rate currently sitting at 1.5%, a full two percentage points below the level the RBA board believes will keep inflation steady and growth at trend, that line was taken by some as a signal the RBA is preparing markets, businesses and households for a huge 200 basis points of tightening over the next few years.

That was despite the RBA admitting there was “significant uncertainty” around its neutral policy rate estimate.

Just how the economy would cope with tightening of that magnitude over a relatively short period of time is highly debatable, but one suspects the answer would be not well.

The consumer spending outlook remains fragile. Photo: Brendon Thorne / Getty Images

As Evans says, given weakness in the household sector that already exists, and with prospects for a pickup anything but certain, it hardly seems like an opportune time to begin a speculative series of rate hikes to counter what may happen in the years ahead.

Why jump the gun and hike without seeing any sign of a pickup in growth and inflationary pressures, essentially?

Both GDP growth and core inflation are still very weak by historic standards, and, as was seen yesterday, merely a whiff of rate hike speculation can lead to market moves, such as that in the Australian dollar, that make achieving a pickup in growth and inflation even harder to achieve.

Although some remain confident that higher rates in the near-term won’t derail what, in its infancy, is looking like a promising economic recovery, a majority of major bank economists, like Evans, are still forecasting that official interest rates are unlikely to move for at least the next 12 months.

As the RBA continues to point out, “the outlook for growth and inflation mean that developments in the labour and housing markets continued to warrant careful monitoring”.

That, as it has been for some time now, will determine what will happen next.