Rate cut looms as Reserve Bank’s outlook weakens

The Reserve Bank is almost certain to greet the incoming government with a cut to official interest rates.

Rate cuts are likely after the RBA cut its forecasts.

The Reserve Bank is almost certain to greet the incoming government with a cut to official interest rates after trimming its outlook for household consumption and downgrading its economic growth and employment outlook.

After sitting on the sidelines this week and extending its record run of holding the cash rate steady at a historic low of 1.5 per cent, the central bank’s quarterly review of its economic outlook revealed the RBA had lowered its forecasts for inflation and near-term economic growth.

It now expects core inflation to be 1.7 per cent by the year’s end, still well short of its target of 2-3 per cent, which it has undershot for years.

GDP growth is now forecast to hold at around 2.75 per cent until mid-2021. This is down from its previous forecast of 3 per cent growth for 2019. That puts it well below the long-term average of 3.25 and marks the second downgrade to economic growth forecasts since the start of the year.

The RBA also triggered a downgrade to its household consumption growth forecasts, slashing its expectations from 2.75 per cent to just 2 per cent and labelling the figure — which accounts for 60 per cent of all domestic economic activity — as the “key source of uncertainty” for the local economy.

“The near-term outlook for consumption growth has been revised lower because weaker housing market conditions and income growth are likely to continue to drag on spending,” the RBA said.

As house prices continue to fall across the country, amid weaker than expected growth in lending across the economy, household consumption has come under severe pressure and has begun filtering through to lower rates of construction, retail sales and care sales. House prices have are down almost 10 per cent across the country, with falls of more than 14 per cent in Sydney and 11 per cent in Melbourne. Both cities account for nearly half of the country’s housing stock.

Local activity is also feeling the pinch amid a global trade spat between China and the US, the world’s two largest economies.

“Economic growth in Australia was weaker over 2018 than expected,” the RBA said. “There are a number of global and domestic uncertainties for the forecast,” its quarterly Statement on Monetary Policy said. “There continues to be uncertainty about how the unemployment rate will evolve and how quickly any tightening in labour market conditions might feed into wage pressures and so inflation.”

On Tuesday, RBA governor Philip Lowe pinned any future movements in the cash rate to the health of the unemployment rate, after the headline inflation rate — a key reading on the health of the economy — stalled at zero per cent in the March quarter.

With the RBA now conceding that the jobless rate will take longer to fall below 5 per cent than previously expected, it is likely to trigger a series of cuts to the official cash rate which will take it to a new record low of just 1 per cent.

WEB business Somp year-ended graph

“The domestic forecasts are conditioned on the technical assumption that the cash rate moves in line with market pricing, which implies two 25 basis point cuts to the cash rate,” the RBA said.

Westpac chief economist Bill Evans said there was a valid question as to whether or not the RBA should cut rates immediately.

“It seems clear therefore that the RBA now believes that it needs to cut rates to barely achieve an acceptable outcome” in meeting its economic targets, Mr Evans said.

Financial markets believe the RBA will cut for the first time since 2016 in August, which would coincide with Labor’s proposed mini-budget, should it win government. Economists believe a second cut would take place as early as November.

“The RBA may choose to move earlier than August, although given the strong first quarter for employment growth and the notorious volatility of the monthly employment reports, it seems likely that a prudent central bank would wait until August for its first move,” Mr Evans said.

The RBA said tax cuts announced in Josh Frydenberg’s federal budget could offset some of the weakness in the household sector. Labor has also pledged to provide tax relief for lower-and-middle income workers if it wins office.

Commsec chief economist Craig James said the RBA was “no doubt” hoping that fiscal stimulus was applied over the next year through tax cuts and targeted spending. “The infrastructure boom will also be fundamental in driving the economy,” Mr James said.

According to the Australian Bureau of Statistics, the 2018 jobs boom was almost entirely driven by growth in public sector jobs, with private sector employment contracting through the year.

The banking sector will also be under significant pressure to pass on rate cuts to households. The RBA called out the major lenders this week for failing to pass on dramatically lower short-term funding costs after market interest rates moderated after a sharp rise last year.

The banks’ wholesale funding cost, measured by the spread of the 90-day bank bill rate over the three-month overnight index swap rate, closed last month at 23 basis points.

This week, the Reserve Bank of New Zealand cut its official interest rate and Dr Lowe’s New Zealand counterpart, Adrian Orr, said it was “much better for monetary policy just to get on with its job” and cut rates rather than waiting for further evidence of weak economic activity.