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Tuesday, June 26, 2012

Westpac drops July RBA rate cut: year-end forecast stays at 2.75%

As I explained here, there are wide divergences in the year-end RBA cash rate forecasts. For example, Market Economics and Credit Suisse are the two most bearish with 100 basis points of cuts forecast to a 2.5% cash rate by December. Closely following are Westpac and 4Cast at 2.75%. In contrast, at least 13 economic forecasters are saying we will either get no more cuts (ie, cash rate stays at 3.5%), or just one more to 3.25% before end December. Yesterday Westpac notified clients that they have now dropped their previous forecast of a July cut, although they still hold their projection of three more cuts before the year is out:

The Reserve Bank Board meets next week on July 3. We had expected the Board to decide to cut rates by 25bps. However, the contents of the Minutes for the June Board meeting make it clear that a cut in July is unlikely. Despite what we considered to be a sound case to cut rates on domestic grounds in June the Board did not agree. The Minutes revealed that the decision to cut was “finally balanced”, and “recent domestic data had not suggested a significant weakening in conditions compared with forecasts a month earlier”.

The justification for the decision was entirely around “clear evidence suggesting a softening in global conditions”....Prior to the June meeting we assessed the neutral overnight cash rate to be 4%, 25bps above the official cash rate at the time of 3.75%. That is, policy was only mildly stimulatory. With the recent cut of the cash rate to 3.5% and neutral following slightly to 3.95%, the policy stance at 45bps below neutral is still only slightly in the stimulatory zone – described by the Board as “a measure of stimulus”.

When the overnight cash rate bottomed out at 3% in 2009 it was around 150bps below neutral. Furthermore, that was a time when fiscal policy was extremely stimulatory (a cumulative stimulus of 6% of GDP in 2008/9 – 2009/10 and the Australian dollar was around USD0.80. In clear contrast, today fiscal policy is now contractionary (the RBA estimates that the 2012 Budget is likely to subtract something between ¾ to 1 ½ percent from growth in real GDP) and the Australian dollar is above parity at a time when the terms of trade are declining. Financial conditions could hardly be described as stimulatory. Since the last Board meeting the GDP report for the March quarter printed growth of 1.3% (4.3% annual). That annual number is exaggerated by base effects. The quarterly number was largely driven by consumer spending (up 1.6%) and, predictably, mining investment, which added 0.9ppts and 1.1ppts respectively to growth. Other components were quite weak with residential investment, equipment investment, commercial building, exports and hours worked all contracting...

The second theme of the June Board meeting was around taking some time to assess the impact of the earlier reductions, with the Minutes noting: “there had not been time to assess the effects of the earlier reductions in the cash rate”.

Since the last Board meeting there has been no extremely adverse global development. The Chinese data would be continuing to surprise the RBA on the downside while Europe continues to be a rolling crisis followed by a ‘band aid’ bail out. Over the last two weeks during my time in Europe I have been struck by the utter despair and uncertainty associated with European developments. The US, as we expected, remains caught in a secular phase of low growth as agents adjust to the overhang of excessive debt in the household and government sectors.

However, as indicated by global bond rates, there has been no further step down in global financial conditions which might prompt the Board to move in spite of its clear intentions as indicated in the Minutes.

Our argument that financial conditions are hardly stimulatory, interest rate sensitive parts of the economy are struggling, inflation is low and that global uncertainty will continue to undermine confidence still support our forecast of a further 75bps in RBA rate cuts.