Economy needs rate cuts to boost employment: RBA

Markets have priced in earlier and larger cuts in interest rates after the RBA boss said two cuts were needed.

Dr Lowe called for “additional fiscal support, including through spending on infrastructure; and structural policies that support firms expanding, investing and employing people.

Australian financial markets have rushed to price in earlier and larger cuts in interest rates after Reserve Bank governor Philip Lowe indicated two cuts were needed to stop unemployment rising, and an even lower jobless rate will be needed get inflation back up to its target band.

The S&P/ASX 200 share index climbed 0.4 per cent to a fresh 12-year high of 6500.1 in response, extending its post-election surge after Prime Minister Scott Morrison was returned with a majority government. The Australian dollar dropped 0.5 per cent to US68.70c, and benchmark 10-year Australian commonwealth government bond yields fell 4 basis points to a record low of 1.63 per cent.

Banks and housing-related stocks surged on expectations of interest rate cuts and a proposed relaxation of macro-prudential policy by the Australian Prudential Regulation Authority. APRA said it would look at removing its guidance that banks should assess whether borrowers could afford their repayment obligations using a minimum interest rate of at least 7 per cent, and instead allow them to set their own minimum.

The market-implied probability of the RBA cutting the overnight cash rate to a fresh record low of 1.25 per cent in June soared to 92 per cent, from 69 per cent on Monday. The market was fully expecting a second cut to 1.0 per cent by November.

A 0.75 per cent cash rate was pegged as an 88 per cent chance a year from now, according to an analysis of market pricing by Westpac.

Economists rushed to bring forward their expectations of interest rate cuts after the RBA released surprisingly dovish minutes from its May board meeting and a widely watched speech by Dr Lowe showed the central bank now has a clear preference to cut rates. Westpac, CBA, ANZ, NAB, AMP Capital, JPMorgan, Nomura, Barclays and RBC predicted a June cut and most tip another cut in August.

In a speech to the Economics Society, Dr Lowe emphasised the fact that the RBA’s recent economic forecasts were based on its normal technical assumption that interest rates would move broadly in line with market pricing. At the time the forecasts were prepared, market pricing implied that the cash rate was expected to decline to 1 per cent over the next year.

“If instead we had used an assumption of unchanged interest rates, the growth forecast would have been lower and the forecast for unemployment would have been higher,” he said.

With the federal government now having a strong mandate to implement tax cuts, Dr Lowe called for “additional fiscal support, including through spending on infrastructure; and structural policies that support firms expanding, investing and employing people.

“Relying on just one type of policy has its limitations, so each of these is worth thinking about,” he said.

Westpac chief economist Bill Evans said the central bank’s current forecasts of 2.6 per cent economic growth and 1.75 per cent core inflation in 2019, and a 5 per cent unemployment rate until the end of 2020, were “underwhelming despite the assumption around lower rates”.

Mr Evans said a follow-up cut in August was likely because he predicted that inflation data on July 31 will show underlying price growth of 0.7 per cent for the first half of 2019, making it difficult for the RBA to persist with a 1.75 per cent forecast for underlying inflation in 2019.

“Downgrading the underlying inflation forecast to 1.5 per cent in 2019 will make it difficult for the RBA to credibly forecast a return to 2 per cent inflation in 2020,” he said. “The RBA may choose to persist with overly optimistic forecasts but will need to ease again to emphasise its inflation-targeting credentials.”

He also expected economic growth data on June 5 to confirm the RBA’s recent downbeat assessment of the consumer, with consumer spending growth in 2019 revised down from 2.5 per cent in February to 2.0 per cent in May.

RBA minutes said “the risks to consumption were tilted to the downside”, and its forecast for the unemployment rate to remain around 5 per cent through 2020 before falling to 4.75 per cent in 2021 “implied that spare capacity would remain in the economy for some time”. It said the outlook for China and international trade were a “significant uncertainty for the global growth outlook”, with tensions escalating.

The minutes reiterated that it would be “appropriate” to cut interest rates if the unemployment rate rose but inflation did not.

But they also said it would be “appropriate” to cut if unemployment did not fall, since the international experience and recent domestic inflation data show a lower unemployment rate would still be consistent with the RBA achieving its 2-3 per cent inflation target.

Thus the RBA conceded that Australia’s non-accelerating inflation rate of unemployment has now fallen below the historical NAIRU of 5 per cent, a theme also emphasised by Dr Lowe in his speech. “From today’s perspective, I think we can do better than this,” he said.

Dr Lowe said his assessment of the accumulating evidence was that the Australian economy could support an unemployment rate below 5 per cent without raising inflation concerns, consistent with the experience overseas, with many other advanced economies sustaining lower rates of unemployment than previously thought possible without leading to a noticeable uplift in inflation.

“The governor’s thinking has evolved over the year to accept that, as we have observed in other countries, upside inflation risks are consistent with a lower unemployment rate than had previously been assessed,” Westpac’s Mr Evans said.

“For Australia, the bank had believed that the key unemployment rate was 5 per cent. Dr Lowe now accepts that he can drive the economy harder with an associated lower unemployment rate without risking any inflation overshoot.”

But while a second interest rate cut would also be consistent with the assumptions that have underpinned the RBA’s May economic forecasts, Mr Evans is not expecting the RBA to cut below 1 per cent, even though it should “extract ongoing ‘dividend’ from the rate cut cycle” by not precluding further action after cutting rates again in August.

“Our current assessment is that with the housing market stabilising in 2020 and the RBA uncertain about the impact of sub-1 per cent cash rate on the economy the eventual low point in the cycle will prove to be 1 per cent,” he said.