Bulletin

30 March 2012

April meeting live but May is more likely: RBA on track for two more cuts by July

The Reserve Bank's board next meets on April 3. In our

minds the case for further cuts following on from the 50bps delivered late last year has already been made. If it were our decision to make, we would certainly move next week.

The Bank's decision will be finely balanced and as always

determined by subjective judgements. For the Board to cut rates, it will need to be absolutely comfortable that the threshold for a move which has been clearly communicated in recent statements - that "demand conditions weaken materially" - has been crossed. While we believe that this condition has already been met, we feel that on balance a prudent central bank will decide to wait. Therefore we are maintaining our forecast for the next rate cut to be in May, followed by July.

A number of negative forces are acting on the Australian economy, including the high Australian dollar, the deleveraging of the cautious consumer and a tightening of fiscal policy. The first two forces are unavoidable headwinds to certain sectors of the Australian economy, being associated with longer term adjustments. While these changes in the Australian economy might be described as structural the inevitable outcome from a once in a century surge in Australia's terms of trade and the necessary adjustment to Australia's excessive accumulation of household debt it is appropriate for both fiscal and monetary policy to support demand through this difficult transition period. In this regard we had been intrigued by recent commentary from a number of Reserve Bank speakers. Our concern has been that the Bank might see changes in monetary policy as irrelevant when the economy is going through profound structural change. Since the last Board meeting we have seen two important speeches from Deputy Governor Lowe and Governor Stevens. On both occasions considerable attention was given to the theme of structural change. On March 19 in a speech in Hong Kong, the Governor clarifies the Bank's position on whether demand management is appropriate at times of structural change when he notes that "monetary policy cannot raise the economy's trend rate of growth. That lies in the realm of productivity increasing behaviour at the enterprise, governmental and intergovernmental levels"; "nor can monetary policy obviate the pressure for the production side of the economy to change in response to altered relative prices". He is asserting that monetary policy cannot change the course of supply side events. That is a point with which we agree.

This is by no means a clear cut issue. It is our view that

the Bank has moved much closer to a move over the last few weeks. And we certainly anticipate that the language in the statement following the April meeting will signal that clearly.

We note that market pricing has moved towards 100%

pricing for May (in line with our position, up from ~80% last week) and an entirely reasonable ~50% for April (37% last week), with an extra 25bps by July. We interpret this as full recognition that two 25bps cuts are required, rather than the 'one more and done' or 'on hold' views that emerged after the surprise February decision.

We invite readers to consider the arguments below.

In Westpac's recently released quarterly report, Coast to Coast, which reports on the economic performance of Australia's individual states, the nature of Australia's multi speed economy is starkly emphasised. Demand in the three states which have no significant exposure to the mining boom has contracted. South Australia (0.6%) and Tasmania (0.7%) contracted in 2011 while Victoria contracted by 0.4% in the second half of 2011. NSW has received a timely boost from its coal sector but it has still only managed to grow at a below trend 2% in 2011. By way of contrast demand surged in Queensland (10.0%) and Western Australia (11.1%). Overall, growth in demand in Australia in 2011 was a "respectable" 4.4%, a figure which belies the extreme disparities between states. Not surprisingly, the job market was particularly weak in the non mining states. Over the last six months (to February) jobs contracted sharply in Victoria, 1.0%, and declined in New South Wales, SA and Tasmania. Only Western Australia registered an above trend performance.

Australia: the domestic growth mix

3.0 ppts cont'
Contributions to qtrly domestic demand growth

ppts cont' Q2 Q3 Q4

3.0

Q4 2.0

Q1

2.0
Mining investment boom Unwinding fiscal stimulus

1.0

1.0

0.0
Housing sector weakness

0.0

-1.0 consumer housing business

Sources: ABS, Westpac Economics

-1.0

public

demand

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30 March 2012
Equally we are relieved to see that he accepts that monetary policy does have a role to play on the demand side, "Monetary policy can play a role in supporting demand to the extent that inflation performance provides scope to do so". He gives further support, "Overall recent economic performance in Australia is not too bad... but neither is it so good that it cannot be improved. The full range of policies macroeconomic and structural need to play their part in seeking that improvement". There are echoes here of US Fed Chairman Bernanke's offering at the Jackson Hole conference last year, where the theme was long run growth. He noted that while monetary policy was not a supply side weapon, it could play a role in improving short term labour market outcomes, thus ameliorating some of the negative long run effects of unemployment, such as skill erosion. It is important to note that this urgency was not apparent in the speech we saw from Deputy Governor Lowe, which also focussed on structural change, which was delivered 12 days earlier. In that speech we saw a much more relaxed approach from the Bank, "the various cross currents have balanced out reasonably well from a macroeconomic perspective: GDP growth is close to trend, inflation is consistent with the target, interest rates are around average and unemployment is low". Of course in that intervening 12 day period we saw a number of developments which might explain the progression from the Deputy Governor's position to that of the Governor. Firstly, the GDP Report for the December quarter of 2011 printed 0.4% for annual growth of 2.3%. This was the fourth consecutive year when GDP had printed well below the accepted trend growth of 3%. (The economy expanded by 1.2% through 2008, by 2.7% through 2009 and by 2.2% through 2010). The RBA's forecast for growth in 2011, with full knowledge of the first three quarters, was 2.75% indicating that its forecast for GDP growth in 2011Q4 was around 1%, an "above trend" quarter, compared to the result of a decidedly below trend quarterly and annual result. It is true that the Bank's forecast for growth in 2012 is an 'at trend' 3% to 3.5%. But that is only a forecast and is likely to be reassessed given the weak momentum indicated by the December quarter in 2011. So the 'relaxed' Lowe speech was based on the 2% expectation for the year that was defeated by the weak Q4 print, while the Stevens speech was informed by the reality of underwhelming growth. Digging deeper into those numbers, growth in domestic demand at 0.2% in Q4 was its slowest since the June quarter in 2009. Growth in private final demand was 0.1%, the weakest outcome since the March quarter 2010. Admittedly the domestic demand print followed a particularly strong 2.2% in the September quarter. That dramatic swing was largely due to the 'correction' to the pace of growth in business investment from 14.2% in the September quarter to 1.0% in the December quarter. But the other key components of private spending are not distorted in this way. Residential dwelling investment contracted by 3.9%, following a contraction of 0.2% in the September quarter to register the weakest quarter since the June quarter of 2009. Household consumption growth printed 0.5% following 1.1% in the September quarter. This represented the softest growth in household consumption since the March quarter 2010. Secondly, the February employment report registered a loss of 15,400 jobs and a rise in the unemployment rate from 5.10% to 5.24% despite a 'helpful' fall in the participation rate from 65.3% to 65.2%. This current read on the unemployment rate puts it on the limit of Dr Lowe's, 5% to 5%, noting his comment, "An important indicator here is the labour market with unemployment rate having been in the 5 to 5% range over the past year. If the unemployment rate were to rise persistently, it might suggest that the contractionary effect of the high exchange rate was more than offsetting the expansionary effect of the investment boom and the terms of trade". Of course it is risky to be too 'relaxed' about the Australian labour market. In 2011 there was zero jobs growth the weakest year for jobs growth since 1992. Despite the lack of jobs the rise in the unemployment rate has been contained to just 0.3ppts (from 4.9% to 5.2%) due to a marked fall in the participation rate, concentrated on males. Overall, it is our assessment that the labour market picture is more disturbing than indicated by the modest rise in the unemployment rate. For example, if the participation rate had held steady since September the unemployment rate would have increased to 5.8%. While that is an extreme example, it highlights the underlying weakness that we believe to be present. A broad measure of labour market health that is not 'distorted' by participation, the employment to working age population ratio, has fallen by 0.78ppts over the year to February. There was also a sharp fall of 5% in the Consumer Sentiment Index for March, largely in response to consumers' concerns around the economy, employment and interest rates. The Index has now fallen to 96.1 which is below the level in October which preceded the two rate cuts in November and December. An additional measure in the Index Unemployment Expectations moved adversely by 4% to register the lowest level of confidence around job prospects (apart from the global financial crisis and one observation in 2001) since the recession of the early 1990s. This deterioration is evident across a wide range of occupations and demographic strata.

Unemployment expectations versus actual

4 3 2 1 0 -1 -2
shaded areas are recessions and GFC *smoothed

std devns
+1.7 std devns from LR avg

ppts

4 3 2 1 0 -1 -2

-3 -3 Feb-77 Feb-82 Feb-87 Feb-92 Feb-97 Feb-02 Feb-07 Feb-12

Sources: ABS, Westpac-Melbourne Institute

Regular readers will be aware that we have been less constructive than the RBA on global growth. As an interesting aside, the Governor has actually been in Asia recently, principally to conclude a landmark FX agreement with the People Bank's of China. This trip would have exposed the Governor to the current reality on the ground. Note that the Bank's commentary on China and Asia went like so in the statement following the March meeting: "Growth in China has moderated as was intended, but on most indicators remains quite robust overall. Conditions around other parts of Asia softened in 2011, partly due to natural disasters, but are not showing signs of further deterioration." The general tone of those comments is clearly removed from the reality as we see it. It is quite possible that the Governor's meeting schedule may have qualified his view on the balance of

Past performance is not a reliable indicator of future performance. The forecasts given above are predictive in character. Whilst every effort has been taken to ensure that the assumptions on which the forecasts are based are reasonable, the forecasts may be affected by incorrect assumptions or by known or unknown risks and uncertainties. The results ultimately achieved may differ substantially from these forecasts.

30 March 2012
risks around the China story. That would have material implications for the Bank's thinking on trading partner growth and the terms of trade. It is no coincidence that there was a steep decline in the iron ore price in the month leading in to the first cut last November. While the prices of key commodities have been stable or higher in the year to date, if the Bank is relenting on its 'quite robust' assessment of Chinese growth, then the policy calculus will be undeniably altered. Another matter worth addressing is the tactical approach of the Bank with regards to the impending CPI report, which will not be available for the April meeting but will be available in May. Our view is that the Bank has a different attitude to waiting for inflation reads in tightening and easing cycles. It is more inclined to pre-empt while easing and less inclined to do while hiking. In the current disinflationary environment, there seems to be little risk moving ahead of the CPI. For what it is worth, we anticipate a benign 0.6% reading on underlying inflation and 0.7% on headline, due April 24. So the timing of the CPI is not a restraint on the Bank if they were convinced that a rate cut was the appropriate policy, hence our assessment that market pricing for April of as high as 50% is not unreasonable. Clearly these near term prospects are clouded by nuances, data volatility and subjectivity. Consequently we are much more comfortable with our expectation that by the end of the September quarter the overnight cash rate will be lower by 50bps than we are in the monthly path to reach that end point. Clearly there are multiple month by month permutations and combinations that fit that structure. Following the example of the Bank's decision in February to defy market expectations, we cannot rule out any particular month for the two moves we expect over this period. Bill Evans, Chief Economist

Iron ore prices & the RBA board schedule

200 190 180 170 160 150 140 130 120 110 Jan-11 TSI 62% fines benchmark
Sources: Westpac Economics, Bloomberg, RBA.
Dec 6 Feb 1 Oct 4 Apr 5 Jun 7 Jul 5

USD/t
Mar 1 May 3 Aug 2 Sep 6

USD/t

200 190 180 170 160 150 140 130 120

Feb 7

Mar 6

Nov 1

Apr-11

Jul-11

Sep-11

Dec-11

110 Mar-12

Past performance is not a reliable indicator of future performance. The forecasts given above are predictive in character. Whilst every effort has been taken to ensure that the assumptions on which the forecasts are based are reasonable, the forecasts may be affected by incorrect assumptions or by known or unknown risks and uncertainties. The results ultimately achieved may differ substantially from these forecasts.