Economic and Financial Market Update: Pump Up The Jam

Summary:

• The RBA kept the cash rate unchanged at 1%;

• The accompanying Statement made it clear that the risks are clearly tilted towards a lower cash rate;

• The economy has not been strong enough for long enough;

• And it remains too weak;

• There are reasons to be positive;

• But the negatives get the headlines;

• Economists and financial markets agree that two more quarter percentage point rate cuts will be required;

• The real economic tonic may require an end to the Trade War and further fiscal support.

‘Pump up the jam, pump it up

…..

Pump it up a little more’

‘Technotronic’

You couldn’t hit a dance floor in the early 1990’s without hearing the Technotronic worldwide hit, ‘Pump Up the Jam’. The lyrics were not Bob Dylanesque, although the music had that eighties/nineties catchiness. Pumping Up the Jam was all about getting ‘a party started’. Right now, Pumping Up the Jam is something that everyone (notably global central banks) would like to happen for the domestic and global economy. The RBA kept the cash rate unchanged at 1% followings its September meeting, but made it clear that further cash rate reductions may be required. Below is an assessment on how close the economy is to party-time.

The Australian economy has not been strong enough for long enough

After a sluggish period post mining boom, the Australian economy had a good run for much of 2017 before slowing over the past year. This meant the economy was not strong enough for long enough. Firms report that capacity utilisation is only around its long-term average. The underutilisation rate (the unemployment rate plus those working part-time that want a full-time job) is well above average. The surest sign that the economy has not been strong enough is the lack of pricing pressure. Inflation is comfortably below the RBA’s 2-3% inflation target. Wages growth is also well below its long-term average.

And the economy is not getting stronger

To achieve higher inflation and wages growth will require stronger economic growth. But the evidence is that the economy is running at a below-trend pace. The GDP numbers suggest an economy in the first half of the year has been running at a ‘1%-plus’ pace (a more-typical speed would be 2.5%), slower than RBA expectations. Even at this early stage, the near-term GDP forecasts provided by the RBA in August are looking tough to achieve. 

The GDP numbers are consistent with feedback from firms that business conditions are sub-normal. Consumers also think that the state of their own finances is below average. The clear exception to this downbeat news is that jobs growth that has been robust over the past couple of years (leading to a record high participation rate).

There are reasons to be positive

So the economy needs to get stronger. And there are reasons to think that things could get a little more lively. The RBA has reduced the cash rate to a very low level, improving firms and consumers’ ability to service debt. This has boosted firms’ profitability at a time when the operating environment is getting tougher. Interest payments are also taking a smaller share of consumers’ disposable incomes. But there is a reasonable chance that households will use this extra income to payoff debt (although this helps to boost future spending).

The lower exchange rate is another plus. It has helped boost the trade surplus to its highest level in over 40 years (high iron ore prices and volumes have also been important, as well as weaker growth in imports). While tax cuts are adding dollars to consumer pockets it is uncertain how much will be saved (or used to payoff debt). The September quarter retail sales numbers will help provide the answer. It looks increasingly like that high commodity prices, decent profitability and lack of recent investment will see mining firms boost capex budgets. The RBA has noted a bottoming of house prices (notably in Sydney and Melbourne). There is still plenty of spending on NDIS.

Cranes and hard hats are in high demand from the big infrastructure spend. But right now it is hard to further boost infrastructure spending given signs of labour and material shortages (Victoria say they are struggling to go enough sand, gravel or concrete). 

But the negatives get the headlines

But given the mood music we have been hearing over the past year it is hard to get people to hit the economic dancefloor. There is a significant decline of residential construction activity underway. Building approvals have fallen by about a quarter from their peak, with further declines likely. Tax cuts will boost consumers’ disposable incomes. But sustainable rises in household spending will require bigger pay packets. Even if the economy starts to pick up the level of the underutilisation rate suggests that wages growth is likely to be modest for at least the next year, or two.

Another concern is that with profit margins under pressure and revenue growth slowing, firms’ may look to cut costs. And with labour the biggest part of most firms’ cost base this could lead to slower jobs growth. This is consistent with data indicating a weakening of firms’ employment intentions, a slowing in the growth of job ads and some rise in concern about consumer views on the unemployment outlook.

But the most significant negative is the global economy. The German economy is most likely already in recession (trouble for the wider European economy). The Chinese economy is slowing despite the best efforts of the Government. The US economy is doing OK but is not humming along as smoothly as it once did. Political problems are evident in virtually every economic region. Add to this a Trade (and increasingly a technology) War that is seriously impacting global trade and business investment decisions, and only seems to be getting worse. 

Economists and financial markets believe further rate cuts are needed

Add this all up and both financial markets and economists agree that further rate reductions will be required to get the economy to regain its dance floor mojo. In the accompanying Statement following their September Board meeting the RBA made it clear that the risks are clearly tilted towards a lower cash rate. At the time of writing, both financial markets and economists think that another quarter percentage point rate reduction will be required later this year, and a second in the first half of next year. Financial markets have also priced in a decent chance of a third reduction later in 2020. 

The RBA noted that an extended period of lower period of low interest rates will be required. At the time of writing financial markets are not looking for any increase in rates for at least the next three years.

Source:  Survey from Reuters. Financial markets is cash rate futures soured from Refinitiv Eikon

So the economy is currently not performing well enough. And the expectations are that it will be too tricky for the economy to navigate a bunch of cross winds without further (interest rate) support. ‘Make my day’ was the plea from Technotronic. Making the economy’s day is likely to need more than just lower interest rates. An end to the Trade War and further (domestic and global) fiscal support will probably be required to really Pump Up the Jam.

We live in interesting times!

Peter Munckton - Chief Economist