Thursday, 25 February 2016 12:10

RBA on hold - policy debate in US a key

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BillEvans small headshot WIBIQThe Reserve Bank Board next meets on March 1. We are confident that the Board will decide to keep rates on hold.

The Governor has made it clear that the Bank will be most closely monitoring progress in the labour market and whether there is any evidence of the recent turmoil in financial markets impacting domestic demand in Australia.

In that regard time will be required to get a clear read on those developments. Markets remain reasonably confident that the necessary information will be available by May with market pricing implying around a 60% probability of a rate cut by then.

We remain comfortable with our long held view that rates will remain on hold throughout 2016.

We were not particularly concerned about the lift in the unemployment rate from 5.8% to 6.0% given that the move was consistent with our forecast that unemployment would edge up to around 6%. That forecast has been contrary to the Bank’s forecast that the unemployment rate would continue to fall through 2016. However we do not expect that the RBA to be too perturbed by the result given the month to month volatility and that ‘trend’ unemployment rate estimates continue to track lower.

Evidence around the impact of the financial turmoil on domestic demand will not be clear for some time. Early evidence around consumer sentiment (up 3.5% in February) and business conditions (stable in February) is not pointing to significant signs of any fallout.

Of course the path of the Australia dollar will also be a key input to the board’s deliberations over the course of the next few months. In that regard the path of the US dollar and US monetary policy will be key factors.

Over the last week I have been travelling in the US meeting with policy officials; real money managers; hedge funds and economists.

Some key themes around US monetary policy; the US dollar; and the state of the US economy have become clear.

The starting point is current market pricing. With virtually no FED hikes priced in for the remainder of the year our current call for three hikes by year’s end looks decidedly ‘courageous’. However that needs to be put in the context of a category of views expecting the FED to be reversing its December rate hike and moving rates into negative. Those low end expectations are skewing market pricing and masking the forecasts of other participants who are expecting a series of FED moves over the course of 2016.

The areas of serious debate are around the US’s current potential growth rate. With very weak productivity growth; growth in the working age population having slowed; and the participation rate weak, even allowing for improving demographics, estimates of potential growth in the US are stuck in the 1.3–1.7% range.

General forecasts for growth in 2016 are around 2%, almost exclusively because of the boost in spending from consumers as strong employment growth boosts incomes and households decide to spend more of the windfall from falls in the oil price (current estimates are that only around 50% of windfall has been spent). Little hope is held out for postive growth contributions from government, inventory accumulation or investment while net exports can be expected to remain a drag.

However, if growth does exceed potential then further falls in the unemployment rate can be expected. Concerns around a sudden lift in wage pressures (which are already building) once the unemployment rate reaches, say, 4.5% are held in many quarters (the debate around the actual level of the NAIRU is lively). Lags between wages and inflation are estimated at around six months making the FED’s inflation target of 2% easily achievable and even posing a potential need to lift the Fed funds rate. This scenario is clearly the key risk to current market pricing.

Evidence is cited that in US states where the unemployment rate has fallen below 4.5% wages growth has reached 3–4%.

This indicates that the link between wages and the unemployment rate still holds although at levels of the unemployment rate that are well below what had previously been expected to be the trigger point. It was further speculated that the lift in wages growth might be non-linear.

On the other hand there is clearly discomfort with the elevated level of the USD (considered to be the most important source of tightening financial conditions). Official research points to the impact on the US economy of the US dollar having long lags (it is notable that since the Fed raised the federal funds rate in December the US dollar index has fallen somewhat). The impact on growth of the 25% lift in the USD over the last two years is still to fully work through the economy. Resumption of the FED’s tightening cycle by June might risk a further substantial lift in the USD, intensifying the drag on the economy.

Earlier periods of USD strength have been associated with much stronger growth particularly due to strong productivity so a 0.5% drag from exports is much more significant when potential growth is 1.3%–1.7% than when it is above 3%.

Resolution of this policy dilemma will play out over the next six months or so. It may take policy makers longer than June to assess the US dollar effect on the one hand and the risks to wage inflation on the other.

Our current view is that the authorities will tread a middle ground. Policy will need to be tightened in anticipation of potential wage pressures but will be focussed on avoiding a USD lift through 2016 of more than 8–10%. Clearly the key variables to watch are jobs growth; the unemployment rate; wage pressures and of course the path of the USD.

 

Bill Evans - Westpac Chief Economist

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