Citi insights into reserve bank & interest rates

August 2017

Reserve Bank outlook points north for Interest Rates

By Simson Sanaphay

Reserve Bank of Australia (RBA) governor Philip Lowe likely has a growing sense of confidence towards the Australian economy, as improving employment conditions, steady trade volumes, and continued accommodative policy settings, nudge the economy’s growth trajectory higher.

This constructive macro-economic backdrop creates fertile conditions for the next rate move to be upwards, and it’s pertinent to note the US has already entered an upward trajectory, with Europe currently pondering when to follow.

But despite the positive signposts we don’t expect the current record low cash rate of 1.5% to shift anytime soon, and likely not until late next year.

Our reasoning is that the economy continues to transition towards growth from infrastructure building and non-mining business investment, all while being challenged by highly indebted households, a slowing contribution from housing investment, and at times an overly strong currency.

Even the RBA’s own assessment that core inflation (that excludes energy and food) will struggle to get back to 2% until 2019, implies the RBA won’t be rushing to lift the cash rate, even if it is more confident about the economic outlook.

Despite concerns for higher utility prices, like electricity, inflation continues to be anchored by low wage growth and the creation of new jobs in below average wage occupations.

As such, we don’t expect significant pick-up in wage growth in the near term. Our forecast for the Wage Cost Index, which is used in formulating industrial relations, wages policies and economic analysis, is an increase of 2% in 2017, and 2.2% next year, which will maintain the trend established since June quarter 2014.

And that lack-lustre wage growth is reflected in consumer spending, which has risen only 2.3% in the past 12 months, and has been below average so far this decade.

Household Final Consumption (rhs)

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As the RBA has noted on many occasions, households are also highly indebted, and when combined with low income growth, it creates a trend of households lowering their saving ratio to support spending. This cannot continue indefinitely. Not surprisingly, views about family finances, which lead consumption, are subdued. It is hard to see how consumer spending growth can pick up materially given these headwinds.

The other challenge for the Australian economy is that currency investors have latched onto the RBA’s confident view. Add in improved commodity prices and diminishing US dollar strength on the back of a legislative log jam and lower expectations for rate hikes, and the obstacles are diminishing for the Aussie dollar to revisit recent two year highs.

Despite traders’ optimism, we view the Aussie dollar as being overvalued at current levels, and note that a strong dollar hinders domestic growth and reduces inflationary pressure. We forecast 75US cents on a 6-12 month time horizon. Until then it’s unlikely for the RBA to undertake a rate cut to drive down the dollar, as this may intensify borrowing into a housing market that is already a source of systemic concern, given the high level of household housing debt.

Instead, we believe the RBA will be hoping that the US Fed sticks to its guidance and continues to gradually raise interest rates, despite a more dovish consensus market view. That could force a repricing of the US dollar and put downward pressure on the Aussie dollar. But this could be a protracted process, so the RBA will need to be patient.

We believe the next interest rate movement will be higher, but patience and time are the keys for the local economy to be in a position to better absorb less monetary accommodation.

Simson is Citi's wealth management strategist

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