To complement the rate cut we expect in February next year the RBA might consider a package of policies that would enhance the impact of the rate cut. However our rate forecasts are not contingent on that development.
We are bringing forward the timing of our forecast for the next cut in the overnight cash rate by the RBA from November to October.
By October, we expect that the path of the unemployment rate will be sufficiently contrary to the RBA’s plans that they will have appropriate justification to ease policy a little earlier than we had previously expected.
We recognise that September is also likely to be a “live” meeting but expect the Board will wait for more data, such as the June quarter national accounts, before moving again.
We are also revising down our terminal rate forecast from the 0.75% we forecast on May 24 to 0.50%. We expect the move from 0.75% to 0.50% to occur in February next year.
Developments since our last forecast change on May 24
Since we announced the 0.75% target terminal rate on May 24 a number of factors have strengthened the case for an even lower terminal rate.
The AUD is providing less support than expected. At the time of our May 24 forecast, markets had not priced in the prospect of a 0.75% terminal rate by year’s end. We expected that as markets moved in that direction the AUD would adjust accordingly. Markets have indeed moved to price in that move but the AUD has actually appreciated from USD0.692 to USD 0.702, partly due to the higher terms of trade and the prospect of a lower US federal funds rate.
We expect that the near term boost to demand from the higher terms of trade will be limited by a cautious response from both the private and public sectors.
Since May 24 we have also moved to forecast an easing cycle from the Federal Reserve. Lower rates globally are largely the result of the concern from the Federal Reserve and other central banks around world growth and deteriorating global trade.
Some data releases since May 24 have also highlighted downside risks for demand, wages and the labour market. In particular we have been surprised by the response of consumer sentiment to the rate cuts in June/July, having fallen by nearly 5%. Furthermore, our measure of unemployment expectations has also deteriorated markedly.
Our forecasts of inflation and unemployment emphasise the extent of the challenge faced by the RBA in boosting demand and wages and reaching their own targets. We expect that the RBA will eventually see only one more rate cut, in October, as being an insufficient response.
RBA’s challenge around its forecasts
In its Statement on Monetary Policy (SMP), which will be released on August 9, the RBA is expected to lower its growth forecast for 2019 from 2.75% to 2.50% but retain its current forecast for growth in 2020 to be at trend 2.75%.
On inflation we expect that following the print of the June quarter Consumer Price Index on July 31 the Bank will have to lower its forecast for underlying inflation (trimmed mean) from 1.75% in 2019 to 1.50% and from 2.00% to 1.75% in 2020.
In the August SMP, forecasts for December 2021 will be released and the RBA’s trimmed mean forecast is expected to lift to 2%. The RBA will be signalling an eventual return to the 2-3% target band although the journey will take a year longer.
The real difficulty will come with the unemployment rate where the actual for June has just printed 5.24% compared to the RBA’s forecast of 5.0% in May. In May the RBA was only able to forecast that the unemployment rate would hold steady at 5.0% in both the remainder of 2019 and 2020. That was essentially because it was only prepared to forecast trend growth in 2019 and 2020. A fair rule of thumb is that the unemployment rate can only be credibly forecast to fall if growth is expected to be above trend.
Note that the forecasts in May assumed market pricing which at the time had discounted two 25 bp rate cuts by year’s end. Accordingly the August forecasts cannot be significantly lifted as a result of the rate cuts that have already occurred. However, the cuts have come earlier than expected by the market at the time of the May forecasts and it is now discounting a further cut by year’s end. Those factors provide some further market support for the RBA’s August forecasts.
The unemployment forecast is going to challenge the RBA Governor given his stated desire to drive the unemployment rate down to 4.5%.
Westpac’s own forecast for the unemployment rate by end 2019 is 5.4%. A range of our leading indicators – the Westpac Jobs Index and the Westpac Index of Unemployment Expectations – signal a continuation of the current slowdown in employment growth over the remainder of 2019 and into 2020.
With the unemployment rate holding or drifting higher there seems little justification to delay the cut to 0.75% to November. We expect an October move while recognising that September will be a “live” meeting.
This is a relatively minor adjustment to Westpac’s forecast released on May 24, when we were the first in the market to forecast a cash rate below 1.0%.
At the time we signalled downside risks to that terminal rate but chose to stick with 0.75% partly due to uncertainty about the effectiveness of any cuts below 0.75%.
The response by the banks to the move in the cash rate to 0.75% will be an indicator to the RBA of the likely effectiveness of any further cuts.
An alternative approach to maximise the impact of a rate cut
However, there may be a way in which the RBA could ensure an effective response of a cut to 0.50%.
When the Bank of England cut the Bank Rate from 0.50% to 0.25% following the Brexit vote in June 2016, it supported the economy through a four pronged strategy. This was highlighted by the Bank Rate cut being accompanied by the Term Funding Scheme, a form of policy designed to “encourage banks to pass on cuts in Bank Rate to customers” (boost household demand). The Term Funding Scheme allowed banks (and building societies) to borrow from the Bank of England on a secured basis (subject to appropriate haircuts) at the new Bank Rate.
In supporting the package, The Bank of England noted that:
“Evidence from a number of economies suggests that, as the level of interest rates set by the central bank becomes lower, the extent to which further cuts are passed on by commercial banks and building societies to other interest rates in the economy decreases, making monetary policy less effective… The potential difficulty, from a monetary policy transmission perspective, arises when interest rates are close to zero because it is likely to be difficult for banks and building societies to reduce deposit rates much further. This constraint means that lenders may then face a choice between reducing the pass through of lower official rates to those they charge on loans — in particular rates on new loans — or a period of lower profitability, which, were it to persist, could reduce the supply of lending.”
(Bank of England Quarterly Bulletin, 2018 Q4)
Adopting a package of instruments, alongside a cut in the Bank Rate, ensured the effectiveness of the rate cut (in time, 24 bps of cuts in the variable mortgage rate followed the 25 bp cut in the Bank Rate) and avoided the confidence drag from adopting an “emergency measure” later on, such as a term lending program or asset purchase facility in isolation.
Banks found that the alternative costs of funding – wholesale and term retail funding – were considerably more expensive (around 70bps) than the drawdown costs of the program.
Important to choose a package best suited to the Australian Financial System
The point is that the combination of a rate cut and a financial package appears to have been quite effective in maximising the impact of the cut. The details of any domestic package, of course, would need to be best suited to the Australian financial system. Alternatively, the market’s response to the move to 0.75% might be sufficiently encouraging for the RBA to make the cut to 0.50% without any supporting package.
At a public forum on July 23rd, I asked the RBA Assistant Governor (Financial Markets) Kent about prospects for other RBA policies to support demand in addition to rate cuts. He indicated that the RBA was unlikely to adopt unconventional policy measures, although he was clear that the RBA had considered a number of policies that had been implemented elsewhere in the world from the perspective of what would be most effective in the Australian financial system.
Consequently in the near term there seems little prospect of the RBA adopting a package of policies which would support the effectiveness of its interest rate policies.
Our forecast is that the RBA will cut the cash rate to 0.50% in February. It may be prepared to link the move with a package of other policies, most appropriate for the Australian financial system, that would result in an effective reduction in the mortgage and business interest rates to ensure effective pass through of the rate cut.
However, we emphasise that the rate cut we envisage in February is not conditional on an associated package of other policies.
