Tuesday 13 February 2018 by Stephen Koukoulas Opinion

Australia has three problems – chronic inflation, low GDP and falling house prices

Guest contributor, Stephen Koukoulas says for more than two years, the annual underlying inflation rate has been between 1.6 and 1.9 per cent, locked below the RBA 2 to 3 per cent target. Another quarter or two where underlying inflation is 0.4 or 0.5 per cent, meaning annual inflation at 1.75 per cent, will bring an interest rate cut scenario to the top of the agenda


Australia has an inflation problem

If the latest forecasts from the RBA’s February Statement on monetary policy prove to be correct, underlying inflation will not hit the mid point of the RBA target for at least the next two years, which is as far as the current RBA forecasts extend.

The RBA inflation forecasts are predicated on annual real GDP growth registering what seem at face value, decent levels around 3.25 per cent. If this figure comes to fruition, inflation will still remain low, as the RBA notes. Implicitly, GDP growth needs to be materially faster – say 3.75 per cent per annum – for inflation to accelerate to the middle of the target band.

Conversely and obviously, if there is any slight disappointment on the growth outlook – perhaps with housing being weaker than anticipated, or global conditions undershooting the current rosy outlook that results in annual GDP hovering around 2.75 per cent rather than at 3.25 per cent – the risk on those already weak inflation forecasts from the RBA will be squarely to the downside.

The December quarter CPI figure confirmed inflation was running dead. Underlying inflation is actually decelerating with an annualised increase of just 1.6 per cent in the second half of 2017, down from 2.1 per cent in the first half of the year. 

While there is considerable debate why this inflation undershoot has been occurring, one simple point is that economic growth in Australia has been too low for many years. Since the start of 2013, the average annual rate of real GDP growth has been a tepid 2.4 per cent.  This is a stunning 0.75 per cent per annum below what was considered the long term trend, which means that a large output gap has been accumulated over the time.

The hangover of the global financial crisis is still with us

With the economy underperforming over all those years, it is little wonder that over 13.5 per cent of the labour force is ‘underutilised’ – either unemployed or underemployed.

To reduce this underulitisation in the labour market, by firing up wages growth and in time inflation, the economy needs to grow well above 3.25 per cent for at least a couple of years. Only then will the negative output gap be removed, labour markets tightened, wages lifted and inflation moved back to the middle or even upper part of the RBA target range.

Given the run of recent economic news, it will be hard to achieve and sustain such a rosy outlook.

House prices are falling

Importantly, there is clear evidence that house prices are falling. The Corelogic data confirmed house prices fell 0.5 per cent in January after a fall of 0.4 per cent in December and no change in November.  Early signs from Corelogic point to a further price fall in February.

At one level, this is good news. The risks of a disruptive housing bubble are being removed.

At another level, and more realistically, this runs the risk of destroying household wealth and creating lower equity, especially for many new entrants to the housing market. On top of that, bank balance sheets are increasingly vulnerable if there is any material increase in bad debts and loan arrears.  

Thrifty households unlikely to support GDP growth

We are seeing the some of the impact of this fragility in household income in weak retail spending and soggy overall household consumption spending. A 3.25 per cent plus growth in real GDP will be hard to achieve let alone sustain, unless household spending growth is stronger.

Hiking interest rates in this climate is frankly unthinkable, reckless and folly.

The weakness in housing is not confined to prices.

New construction activity is starting to tail off with the number of new building approvals falling from the highs registered during 2017. By the end of 2018 or early 2019, dwelling investment is set to subtract from bottom line GDP.

However, not all economic risks are to the down side.

Positive business investment but GDP below forecasts

Business investment is looking positive, strong even. This, plus strength in public sector spending, is why a recession is extremely unlikely and growth will be reasonable, albeit below what the RBA is hoping for in its forecasts.

While this segment of good news is locked into the economy for at least the next year, there is a concern that a lift in business investment will have substantial leakage to imports. Almost all of the machinery and equipment, which is at the centre of the favourable outlook for business investment, is imported.

Recent data on international trade saw a solid rise in imports in the second half of 2017, driven by a sharp rise in capital and intermediate goods, with the bottom line deficit blowing out sharply. For the December quarter, an early estimate is that net exports will subtract 0.8 percentage points from GDP. This will be a huge negative counterpoint to the likely strength in capital expenditure.

Forecast December GDP results look like another quarter where annual GDP will be hovering around 2.5 to 2.75 per cent, to be well below the RBA forecasts for the next two years.

In terms of the pressures on monetary policy, the chronically low inflation rate means the RBA cannot and will not increase official interest rates any time soon. Soft economic growth, falling house prices and weak wages all need to improve from current levels before the RBA can seriously think about hiking rates.

Interest rate forecasts – hard data suggests they should be cut

Somewhat surprisingly, given the run of fundamental news on inflation and other hard data, the futures market is pricing in two, 25 basis point rate hikes by the second half of 2019.

These hikes seem to be a function of market players paying too much attention to the US monetary policy cycle, where rates have risen and there are many more in the pipeline. They too easily accept the RBA’s rose coloured glass view of the domestic economy and the wage and inflation outlook.

These issues and the inflation climate are why the markets and the RBA are so fixated with each quarterly CPI release. Each release is scrutinised for news and quirks in inflation, especially for any evidence that it is moving back to the target range.

The data on wages are also the new ‘vital data points’ for the markets and the RBA when judging the monetary policy outlook, given the importance of wages in driving inflation momentum.

To this end, the important Wage Price Index (WPI) data are released on 21 February with the equally important Average Weekly Earnings (AWE) data on 22 February. 

If these data results confirm the WPI and AWE registering 2 per cent annual growth, the rate hike pricing and expectations will need to be revised. Indeed, there is a growing probability of the market moving to ‘take out’ the interest rate hike pricing from the yield curve.

Which begs a left field question - interest rate cuts anyone?

One part of the interest rate outlook that has had precious little attention in recent months is the possibility of an interest rate cut.

The hard data, as opposed to the rosy RBA forecasts, would in normal times be consistent with a scenario of interest rate cuts.

To reiterate - inflation below target, record low wages growth, falling house prices, substantial spare capacity in the labour market and only moderate GDP growth.

Throw in the very real possibility of some emerging global risks and it won’t take much for an RBA and market to do ‘an about face’.

It will be no surprise that by around mid 2018, the monetary policy debate will be more even handed, not just focusing on interest rate hikes.

Another quarter or two where underlying inflation comes in at 0.4 or 0.5 per cent, meaning annual inflation at 1.75 per cent, will bring an interest rate cut scenario to the top of the agenda and it would be no surprise to see those cuts delivered before the end of the year.

Implications for investors

For investors, any ramping up in yields will be moderate and probably short-lived. Global pressures will be to bias yields higher, but the inflation reality check from home will be to keep them contained.

The absence of interest rate rises and prospects for lower rates, should help support currently battered interest rate sensitive stocks and bonds, but will also start to exert a significant downside risk to the Aussie dollar, which looks set to track towards US 70 cents over the next 6 months, rather than sustain a move above US 80 cents.