As far back as 16 February, I put out a call predicting the Reserve Bank of Australia would cut interest rates to 1.5% p.a. by year-end, and that the Australian dollar would fall to US68c. This note provides an update to this long-held view in light of recent events.
The bottom line is that I still expect the RBA to cut rates to 1.5% p.a., but the timing has been pushed out to mid-2016. My call on the $A remains in place, with a decline to US68c by year-end still quite plausible
The Stubborn Refusal of Unemployment to Rise
My call that the RBA would cut the official interest rate to 1.5%p.a. this year was predicated on the view that the economy would continue to suffer through a period of below-trend economic growth – which in turn would place upward pressure on the unemployment rate. Even though economic growth has generally remained sub-par, (e.g. non-farm GDP grew by only 2.4% in the year to end-March 2015), the unemployment rate so far this year has curiously refused to rise. After touching a high of 6.3% in January this year, the unemployment rate has since eased back to only 6.0% by June. In June 2014, the unemployment rate was 6.1%.
The failure of the unemployment rate to rise further has been noticed by the RBA, and has led it to question its previous assumption about what it considers the appropriate “trend” growth benchmark for the economy. Irrespective of whether trend growth has fallen or not, for policy purposes, the bottom line is this: in an environment of uncertainty over “trend” economic growth, the RBA can be expected to be less pro-active in setting policy according to growth indicators, and more reactive to trends in the actual rate of unemployment.
As a result, another interest rate cut by the RBA now appears unlikely anytime soon – and certainly not before we see a clear resumption of the previous upward trend in the unemployment rate. For this reason, we do not expect the RBA to cut interest rates at today’s policy meeting. The next “window of opportunity” for a rate cut is the November policy meeting, which follows the next consumer price index report and is just before a new set of RBA economic forecasts are released.
There will be three more employment reports before the 3 November policy meeting (the next being on Thursday this week). If these reports show the unemployment rate lurching toward 6.5% or more, there remains a very good chance the RBA will feel obliged to cut interest rates in November. Adding to the case for a possible rate cut by this stage would be further signs of a topping out in the housing construction boom and a likely still dire outlook for non-mining business investment in the next official capital expenditure survey (due on 27 August).
We are not wedded to the view the RBA will cut interest rates as early as November. Indeed, supporting the apparent decline in the unemployment rate in recent months has been a tentative lift in hiring indicators, such as ANZ Job ads and the National Australian Bank survey employment index (see chart above).
That said, in view of likely continued sluggish consumer spending and business investment, we continue to forecast subdued sub-3% growth over the coming year. Meanwhile, we also feel it premature to claim trend economic growth has fallen, meaning the recent flattening out in the unemployment rate is unlikely to last. Indeed, we expect the unemployment rate to reach 6.5% at some stage in the first half of 2016. On that view, we expect the official cash rate will still reach 1.5%p.a by June 2016.
$A forecast remains on track
Even though official interest rates are now not likely to fall as far as expected this year, our $A view remains on track. The $A has fallen US4.5c in the 5 ½ months (from US77.5 to US73c) since our year-end US68c call was released. As seen in the chart below, the recent decline in the $A to around US73c has now placed it at broadly “fair-value” – assuming a further 1% decline in the terms of trade in the June quarter.
That said, with commodity prices likely to remain under downward pressure, US interest rates likely to rise from September, and the $A still well above long-run average real levels – a further fall of 5c over the following 5 months still seems quite feasible. Indeed, we anticipate the $A could fall to around US65c by mid-2016, which would still leave it only in line with its long-run average in real terms.