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Oz central bank finally faces facts

Macro 5 minutes to read
Strats-Eleanor-88x88
Eleanor Creagh

Australian Market Strategist

Summary:  It is abundantly clear that the economic outlook in Australia has been deteriorating but the RBA has remained dogmatic, stubbornly clinging to its optimistic outlook. Now, however, things may be changing.

In a speech to reporters at the National Press Club in Sydney today, Reserve Bank of Australia governor Philip Lowe finally recognised the mounting downside risks switching to a more balanced outlook. "Looking forward, there are scenarios where the next move in the cash rate is up and other scenarios where it is down," Lowe said. This is a significant shift away from stubborn optimism that has long prevailed with Governor Lowe opening the door for rate cuts and flexibility in monetary policy settings.

The turnaround is significant as the central bank has consistently underdelivered and maintained a positive outlook despite missing its inflation target for the past three years. Investors should take note that the changing narrative from the RBA marks a critical juncture where the central bank has been forced to concede that the economy is not as robust as it previously let on, much like other policy makers globally have been forced to do. The most prominent being the about-turn from the Fed chairman, Jerome Powell. 

Financial markets were sceptical of the RBA’s narrative before the speech and were pricing in a 60% chance of a rate cut by the end of 2019. Following the speech, the Aussie dollar plunged, and markets are now pricing in an 80% chance of a rate cut by the end of 2019.
AUD price chart
Source: Bloomberg
It is no secret that the RBA has pinned its hopes to strength in the labour market, which has remained a bright spot. The RBA is banking that this strength will offset the negative wealth effect from falling property prices. This wager is still in place, "Over the next year, we are expecting a pickup in household disposable income to provide a counterweight to the wealth effects of lower housing prices.". 

The official unemployment rate fell to 5% in December and is now sitting at cycle lows, but it must be remembered unemployment is a lagging indicator, so the data only gives us a rear mirror view on the health of the labour market. ANZ job advertisements fell in January, a leading indicator that points to a potential drop off in hiring ahead, consistent with our view that economic growth is deteriorating and will continue to do so throughout the year.

Along with other leading indicators, recent data on the slump in building approvals highlights a marked decrease in residential construction to come, pointing to potential weakness in employment in residential construction. As the housing market slide continues it is only a matter of time before jobs are affected, particularly in Sydney and Melbourne where the steepest declines have been felt. We expect the unemployment rate to creep higher as economic activity slows.

The strength in the labour market is going to be crucial in determining the RBA’s next policy move. If, as many of the leading indicators suggest, the labour market strength proves to be transient and the unemployment rate does pick up we can expect a further easing bias to be adopted by the RBA. As previously noted, in our view, this eventuality will be inevitable, and the RBA will move to cut the cash rate, but for as long as employment remains at a cycle low the RBA will not fully capitulate on policy guidance.

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