Westpac now sees rates on hold until 2021 because of looming challenges for GDP growth

Photo: Peter Macdiarmid/Getty Images.
  • Australia’s economy grew at an annualised pace of more than 4% in the first six months of 2018, leaving growth on track to exceed the 3.25% level forecast by the RBA.
  • Despite the recent growth spurt, Westpac doesn’t expect it will last, forecasting that growth is likely to moderate next year.
  • It says this will be “insufficient to make any meaningful impact on the spare capacity in the economy” meaning its inflation, wage and RBA cash rate forecasts remain “essentially unchanged”.

Australia’s economy has surprised more than a few forecasters this year, including the most important of them all, the Reserve Bank of Australia (RBA).

According to the Australian Bureau of Statistics (ABS), the Australian economy grew by 0.9% in the three months to June, leaving the change on a year earlier at 3.4%, well above the 2.8% pace expected by financial markets and 3% level forecast by the RBA just a month ago.

Combined with an upwardly-revised 1.1% increase in real GDP in the March quarter, the 0.9% expansion in the June quarter left annualised growth in the first six months of the year at over 4%, leaving the economy on track to grow faster than the 3.25% level expected by the RBA.

Like most forecasters, Westpac Bank’s Australian economics team, led by Chief Economist Bill Evans, was also surprised by the strong performance from the economy, leaving them no other option but to revise up its forecasts for economic growth this year.

“Due to upward revisions of around 0.5 percentage points, the Australian economy was revealed to be much stronger than we had been led to believe,” Evans said in a note released today.

“We have lifted our growth forecast for 2018 from 2.7% to 3.3%.”

So as opposed to growing around the pace where inflation and unemployment are expected to remain steady, known as “trend” growth, Westpac, like the RBA, now sees the economy growing significantly faster, sitting at levels that should, according to economic theory, help to reduce spare capacity that exists at present.

However, while the latest GDP report has forced Westpac to revise up its growth estimates, one thing remains the same: it still doesn’t see official interest rates being increased by the RBA until 2021 at the earliest.

According to Evans, while GDP growth is now likely to be faster than previously thought, it’s still likely to moderate from the breakneck pace seen in the first half of 2018, making it difficult for lower unemployment to help lift wage and inflationary pressures by any meaningful amount.

“The key here is that following a 2.4% growth rate in 2017, the economy will only register a single above potential growth performance before slowing back to slightly below potential in 2019 with a modest above potential lift in 2020,” he says.

“There is unlikely to be much sustained progress in closing the output gap and delivering higher wage and price inflation outcomes.”

So opposed to the RBA who are banking upon sustained, above-trend growth to help lower unemployment and gradually boost wages, Westpac says the recent growth spurt is unlikely to be maintained, forecasting that GDP will grow by 2.7% next year before picking up to 3% in 2020.

Evans says there’s a multitude of factors that underpin this view, led by an expectation that consumer spending — the largest part of the economy — will slow in the coming quarters as home prices continue to fall.

“This process is expected to persist through the remainder of 2018, 2019, and well into 2020. The adjustments will be shallow but persistent,” Evans says.

“That process will see consumption per capita which has been running at a pace slightly above household income per capita drop below that pace.”

Westpac is forecasting that growth in total labour income will slow from 5% in 2017 to 3.6% in 2019 which, along with expected weakness in home prices and recent decline in the level of household saving to the lowest level in over a decade, should see “consumer spending growth slow from the current 3% to a more modest 2.6% in 2019 and 2.8% in 2020”.

Adding to headwinds for the economy, Westpac expects housing construction to decline as weaker foreign investment, credit tightening by Australian banks, higher mortgage rates and potential changes to the tax treatment of housing mitigate any tailwinds resulting from strong levels of population growth.

It also says political uncertainty will not only weigh on housing construction but also investment and employment plans from firms, two areas the RBA expects will continue to improve in the period ahead.

“Political uncertainty looks set to weigh on firms investment and employment intentions through the remainder of 2018 and 2019,” Evans says, adding “these factors have played out clearly during the election campaigns of 2013 and 2016”.

Along with a deepening drought in Australia’s eastern states, as well as an expectation that global economic growth will slow modestly in the years ahead, it helps explain why Westpac remains reluctant to get too excited about recent strong outcomes in Australian GDP leading to a faster rate tightening schedule from the RBA.

Financial markets, collectively, share a similar view to Westpac when it comes to the outlook for the RBA cash rate, pricing in a greater than 50% chance it will remain at 1.5% by the end of next year.

Earlier this month, RBA Governor Philip Lowe said that should progress towards lowering unemployment and boosting wage and inflationary pressures continue “you could expect the next move in interest rates to be up, not down”.

“This would be a sign that overall economic conditions are returning to normal and would take place against the backdrop of stronger growth in household income,” Lowe said.

“But any move still seems some way off, given the gradual nature of the progress expected on unemployment and inflation.”

Lowe, mirroring the view from financial markets, doesn’t appear to be in a rush to do anything preemptively at this point.

Partially contributing to the RBA’s caution, it described the outlook for household spending as a “continuing source of uncertainty” at its September policy meeting citing weak household income growth and high levels of indebtedness.

Markets will get further clarification on the most important part of the Australian economy today with Michele Bullock, Assistant RBA Governor, delivering a speech on “the evolution of household sector risks” to an Ai Group industry event in Albury.

Until confidence towards households begins to improve, it likely that the cash rate will remain anchored at record low levels for some time yet, fitting with the view offered by Westpac and an increasing number in financial markets.

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