Why we’re sticking with our rates call

If we were at the track rather than the office, the odds would appear to be shortening for a rival horse.

In financial markets, participants are pricing in three Reserve Bank of Australia rate hikes by the end of 2019 with nearly two expected by the end of 2018. After some adjustments to their forecasts last week, the other three major banks are also expecting rates to start rising next year.

Recall that in mid-August last year, these same players (markets and most other banks) were forecasting rate
cuts over the course of the remainder of 2016 and 2017, whereas Westpac’s view at that time was “rates on hold” in both years.

Today, we still expect the RBA to keep the cash rate on hold through the remainder of 2017; 2018 and to the middle of 2019, predicated on our central call of “flat” house price growth through next year and 2019. At the same time, we expect three rate hikes by the US Federal Reserve by the end of next year and a slowing in China, weighing on the Australian dollar, potentially to around US70c by the end of 2018.

Forecasting is of course a difficult game for all participants and officials including the central bank and Treasury.

So why are we out in the cold from the crowd and tipping rates to remain on hold?

Put simply, we expect 2.5 per cent GDP growth next year, well below the RBA’s forecast of 3.25 per cent. For us, concerns around ongoing weak wages growth weighing on consumer spending and eventually the jobs market will dominate the policy debate in 2018, which could impact business confidence. Continued “macro-prudential policies” should also ease conditions in housing markets.

As I see it, 2.5 per cent growth and growing pressure on household budgets from higher energy prices isn’t an environment for rate hikes.

Already, Australians are saving less to finance consumption, the household savings rate falling from 9 per cent to 4.6 per cent over the last three years amid low wages growth of 1.9 per cent in the past 12 months, compared to the average of 3.5 per cent. Australia isn’t alone – a major puzzle for central banks globally has been the limited response of wages to stimulatory monetary policies since the GFC and there are many “structural” explanations, such as globalisation technology, low productivity growth and the absence of pricing power for employers.

But given the global lessons on the structural wages outlook, it seems unlikely that wages in Australia will lift significantly even in the medium term with plenty of excess capacity already in the labour market. And at some point, households will need to protect the fragile savings rate and pressures will emerge on consumer spending, a key reason why we expect growth to slow to 2.5 per cent in both 2018 and 2019, below the estimated trend rate of 2.75 per cent.

In 2016, growth in Australia was strongly boosted by a high-rise residential construction boom. Since peaking mid-last year, high-rise approvals have since fallen by 40 per cent due to greater pressures on foreign investors, restricted mortgage funding from banks, and increases in state and federal taxes. Westpac has been monitoring “late settlement”; “failed settlement”; and valuations relative to original purchase prices for high rise investors, pointing to further reductions in high rise approvals and developments.

We expect that whereas residential construction added 0.35ppts to GDP growth in 2016, it will subtract about 0.43ppts in 2018, a 0.78ppts turnaround. While non-residential building will provide a partial offset and public infrastructure investment will continue to boost growth, the residential building sector is much more labour intensive and has considerably larger multiplier effects on the economy particularly through the retail sector.

Recent house price developments have also been significant.

On a six month annualised basis, house price inflation in Sydney has slowed from 22.4 per cent in January 2017 to 4.8 per cent in August 2017, according to CoreLogic’s recently revised prices series. In the other major market of Melbourne, comparable moves are 15.5 per cent to 10 per cent. After eight years of falling or steady official rates, borrowers would likely respond to rate hikes with caution, one of several developments already unfolding even without official rate hikes.

While the RBA in 2016 arrested similar deteriorations in house prices by cutting rates, prospects of this occurring again seem unlikely.

To us, a 40-month stretch of steady rates in Australia would not be out of place.