First in a three part series from ex ANZ Chief Economist, Warren Hogan, this note assesses the outlook for Australia’s short term interest rates. There isn’t much conviction but the bias is towards higher rates
Background
Global financial markets are increasingly confident the Fed will continue to normalise monetary policy with further rates hikes over the year ahead.
In Australia however, money markets appear to have pulled back from the expectation of a higher RBA cash rate next year. Around the world, long term interest rates and bond yields have been relatively stable despite building momentum in world economic activity and the prospect of less accommodative monetary policy from the world’s major central banks.
Households, businesses and governments can adjust to a gradual increase in interest rates, particularly if underlying economic growth is reasonably strong. While a sharp and sustained rise in interest rates such as that witnessed in 1994 would be highly disruptive to the world economy, just about every fundamental metric that attempts to judge the appropriate level of interest rates based on the performance of the economy is telling us - they should be higher.
The global financial markets don’t seem to believe that interest rates will rise by much or if they do, a period of falling rates will soon follow.
Why? The world economy has accumulated an unprecedented amount of debt. This makes it sensitive to higher interest rates. You could say we are leveraged to a low rate environment and any sustained rise in rates will do substantial damage to world economic activity. This perception is particularly true of Australian households.
In September, Australians borrowed over $27bn to buy houses. That is about 50% higher than the monthly average from between 2005 and 2015. While the growing household debt pile is slowing a little and its composition looks a little less speculative, the fact remains that Australians are borrowing unprecedented amounts of money for housing each and every month.
Economic cycles don’t die of natural causes, they turn because interest rates rise or financial imbalances build to such an extent that the supply of credit is compromised. For these reasons, there is every likelihood the housing market will resume its onward march.
The next big test for housing will be how it performs following the summer holidays. Any signs of a revival in house price inflation come the Autumn of 2018 should be a warning of growing risks in the financial system and economy more broadly when household debt is so high. More importantly, it will be a strong signal that Australia’s interest rates are too low.
Little conviction but bias towards higher rates
Money market prices suggest the RBA will only make a small upward adjustment to interest rates over the next 12 months. As of mid November 2017, various short term money market instruments point to a 50% probability of a single 25bp rate hike in 2018. This market pricing is broadly consistent with the views of professional forecasters. Most commentators and economic forecasters are predicting either stable rates or a couple of 25bp rate increases from the RBA next year.
Consensus is weak with many pencilling in an unchanged cash rate for most of next year.
There are very few talking about rate cuts and a group expecting a series of increases. In this case, it seems like an even spilt between the ‘on hold’ camp and the ‘small increase’ camp. It won’t take much to shift to a majority view one way or the other.
The economy looks to be in pretty good shape
Australia’s macroeconomic transition from the mining boom to more normal drivers of economic activity appears nearly complete.
The weakest parts of the economy in recent years have been those regions most impacted by the downturn in mining investment activity.
In Western Australia and Queensland, both mining and non mining activity has been soft as the contractionary effects of declining mining investment spilt over into non mining industries. This process has nearly run its course.
The non mining states have been building momentum for a couple of years on the back of a broad based construction boom. Construction work is growing strongly across most segments with a particularly strong pipeline for commercial and infrastructure projects. With many either underway or ready to start, the prospect is for strong construction activity and employment for the next couple of years.
Residential approvals are also high and are no longer trending down following the softening seen in 2016. Residential building approvals are now 15% above the low point in late 2016, hinting at a new cyclical lift.
A strong lift in overall activity for the Australian economy as the headwinds from the mining downturn fades
Much of the economic data is suggesting that growth is above its potential rate. This is best indicated by shrinking spare capacity in the labour market where the unemployment rate is gradually declining. The latest ABS figures recorded a new cyclical low unemployment rate of 5.4% in October, well below the cyclical high of 6.25% in late 2014.
Importantly, full time employment growth has been strong this past year, suggesting underemployment is also easing. Most estimates of full employment for Australia are somewhere between 5% and 5.5%. We will only know for sure after the fact but the overall demand and supply balance for labour seems to be gradually shifting in favour of employees.
Business conditions hit a record high in October according to the NAB survey. The monthly index was 21.1 in October, up from 13.7 in September. At the height of the economic cycle in 2007, just before the global financial crisis, business conditions rose to around 20.
The NAB survey is one of the most reliable cyclical indicators of the Australian economy and right now it is telling us things have never been better for business.
Business confidence is also strong, although not as strong as conditions, while the capacity utilisation measure and profitability are trending upwards. Indeed, both the NAB capacity utilisation data and their profitability series are telling us that employment should remain strong over the course of the summer.
If the economy is doing well, why do interest rates need to be so low?
Three reasons to consider:
- Some analysts believe the economy isn’t as strong as the business and labour market indicators suggest. The most important sector of the economy – households – are hardly spending, heavily indebted and worried about the future. Higher interest rates, could easily tip them over the edge.
- Retail sales have barely grown in the past year and overall consumer spending is only expanding at a 3% per annum rate. Consumer confidence is average, at best, despite falling unemployment and rising house prices. Much of the weakness in consumer spending can be explained by very weak retail price inflation and the lowest rate of wage growth in generations. Weak consumer goods prices are having no identifiable effect on volumes. People aren’t responding to ‘sales’ at the shops by spending. Sales are now the rule, not the exception and low wage growth exacerbates the problem.
- The real focus for the more dovish commentators has been a lack of inflation. Inflation is still below the RBA’s target band of 2-3% and the expectation of it rising over the years ahead has been muted by ongoing weakness in wages growth. For many observers, the case for higher interest rates is weak because the risk of inflation rising above the RBA’s target band is low. Why raise rates if the risk of inflation isn’t there?
The answer to that question is financial stability. Low interest rates can create more problems for an economy than just consumer price inflation. Easy monetary policy can encourage excessive borrowing and inflation in the price of assets, most importantly, property.
Property price cycles are a normal feature of a market economy. Lags between supply and demand, movements in interest rates and employment create inevitable variations for property markets. It is when these typical price cycles are exacerbated by speculation and excessive debt accumulation that central banks should worry. With Australian mortgage debt and house prices achieving unprecedented levels over the past five years it is fair enough to ask if there are imbalances emerging.
Monetary policy needs to focus on the risks and leading indicators
When trying to anticipate future economic and financial trends, we need to focus on leading indicators of the economy. Wages lag employment which lags economic activity. For Australia, the construction cycle is leading the way with business conditions and spending more broadly likely to follow. If this sequence is correct, and it has been a pretty consistent sequencing for Australia over the last 30 odd years, then we look set for stronger economic growth and lower unemployment.
This is great news, but it will inevitably generate imbalances in the economy. This will most likely be in the form of property price inflation and financial stability risks; but you shouldn’t rule out rising consumer price inflation, particularly if the currency begins to weaken.
I think the market is right to be focused on the risk of higher interest rates in Australia. Indeed, the market is likely to underestimate the extent to which interest rates can rise over the next few years. This is good news for investors as they can gradually improve returns on portfolios as rates move up. “Gradual” will be the operative word and patience will be rewarded. In a world carrying more debt than ever before, central banks will be cautious in their efforts to normalise interest rates.
Look out for Warren’s ‘Global interest rate outlook’ and ‘The Australian bond market outlook’ in coming weeks.