No Need for Pre-Xmas Rate Change

Domestic and global economic indicators continue to paint a picture of a modest economic expansion with consumer price inflation remaining below the Reserve Bank of Australia’s official target band of 2-3%, official unemployment falling slightly and financial markets remaining bullish. For this month the RBA Shadow Board continues to advocate a hold-and-wait policy. It attaches a 60% probability that this is the appropriate setting. The confidence attached to a required rate cut equals 1%, while the confidence in a required rate hike equals 39%.

Australia’s seasonally adjusted unemployment rate fell yet again, equaling 5.4% in October, according to the Australian Bureau of Statistics, the lowest official jobless rate since February 2013. However, this improvement in the official statistic is the result of an increase in total employment of only 3,700 and a slight drop in the participation rate to 65.1%. Nominal wages growth still equals 2% which means that real wages are barely edging up. The Reserve Bank of Australia, and this Shadow Board for some time now, have raised concern about the low wage growth. It is a drag on domestic consumption and makes household balance sheets more vulnerable in light of their high leverage.

The Aussie dollar, relative to the US dollar, continued its modest decline, most recently trading below 76 US¢. Yields on Australian 10-year government bonds have fallen further, to 2.5%, suggesting that the markets do not expect interest rates to rise significantly in the medium term. The local stock is being held up by the strength of global stock markets, the S&P/ASX 200 stock index’s closing above 6000 for the first time in nine years.

There has not been any significant news from the global economy to revise the overall outlook. Global share markets, propped up by cheap and plentiful credit, continue to advance. While the global economy is gathering pace, there is growing concern that asset values are not justified by their underlying fundamentals. Australia’s trade surplus doubled to AUD 1.75 billion, ahead of market expectations. It is now the 11th consecutive monthly trade surplus, suggesting that the weakened Australian dollar is helping to bolster aggregate demand.

Supply indicators have largely improved in the past month: the NAB business confidence index edged up from 7 to 8, with Alan Oster, NAB’s chief economist, saying that, “the results from the Survey indicate that the business sector in Australia is very strong at present, which is having positive spill-overs into the labour market and investment.” The AIG Performance of Manufacturing Index jumped 6.2 points to 57.3 in November, marking the 14th consecutive month of expansion, the longest expansionary run since the global financial crisis. The Services PMI declined slightly.

On the other hand, demand indicators are looking slightly weaker, with the Westpac-Melbourne Institute Consumer Sentiment index declining 1.7% month-on-month and retail sales remaining completely flat. Consumer credit, as well as private sector credit, have continued to increase at around 0.4% month-on-month.

The real estate markets in Australia’s major cities appear to be cooling, after house prices posting double digit gains for the past couple of years. Construction output in September, the most recent number, peaked at a record high of 15.7%, suggesting that additional supply is in the pipeline which will limit further increases in house prices. The development of the housing market will be an important variable in determining the interest rate path for the next year.

The distribution of the Shadow Board’s policy preferences is virtually unchanged. The Shadow Board is 60% confident that keeping interest rates on hold is the appropriate policy, unchanged for second month in a row. It attaches a probability of 1% that a rate cut is appropriate (2% in November) and a 39% probability (38% in November) that a rate rise, to 1.75% or higher, is appropriate.

The probabilities at longer horizons are as follows: 6 months out, the estimated probability that the cash rate should remain at 1.50% equals 25%, one percentage point higher than in November. The estimated need for an interest rate decrease is 6% (unchanged), while the probability attached to a required increase equals 69% (70% in November). A year out, the Shadow Board members’ confidence that the cash rate should be held steady equals 17% (16% in November), while the confidence in a required cash rate decrease equals 8% (7% in November), and in a required cash rate increase 76% (down 2% from November).