Reserve Bank keeps interest rate options openEconomic perspective
Reserve Bank Governor speech: “The Year Ahead”.Speeches by the Reserve Bank Governor can affect financial markets.
What does it all mean?
The Reserve Bank Governor has delivered a speech “The Year Ahead”
The Reserve Bank Governor now believes that there are equal chances that the next move in official interest rates could be up or down. For some time the Reserve Bank has believed that a tighter job market would lead to higher wages and eventually lead to an increase in the cash rate. The Governor now believes that there are scenarios where the next move in rates could also be down. It all depends on “uncertainties’ – principally, how the fall in home prices in Sydney and Melbourne plays out as well as “uncertainties” in the global economy. The latter refers largely to the US-China trade dispute but also to Brexit and the slower economies in Europe and Japan.
The key paragraphs from the speech:
“Over the past couple of years, economic conditions have been moving in the right direction. The labour market has strengthened, and the unemployment rate has fallen and a further decline is expected. Inflation is also above its earlier trough, although it has not changed much over the past year. Our expectation has been – and continues to be – that the tighter labour market and reduced spare capacity will see underlying inflation rise further towards the midpoint of the target range. Given this, we have maintained a steady setting ofmonetary policy while the labour market strengthens and inflation increases.”
Looking forward, there are scenarios where the next move in the cash rate is up and other scenarios where it is down. Over the past year, the next-move-is-up scenarios were more likely than the next-move-is-down scenarios. Today, the probabilities appear to be moreevenly balanced.
We will be monitoring developments in the labour market closely. If Australians are finding jobs and their wages are rising more quickly, it is reasonable to expect that inflation will rise and that it will be appropriate to lift the cash rate at some point. On the other hand, given the uncertainties, it is possible that the economy is softer than we expect, and that income and consumption growth disappoint. In the event of a sustained increased in the unemployment rate and a lack of further progress towards the inflation objective, lower interest rates might be appropriate at some point. We have the flexibility to do this if needed.”
It’s important to note that the Reserve Bank expects rates to remain on hold for some time still: “(the Board) does not see a strong case for a near-term change in the cash rate.We are in the position of being able to maintain the current policy setting while we assess the shifts in the global economy and the strength of household spending.” The “uncertainties”
The first major “uncertainty” is the global economy: “What is of more concern, though, is the accumulation of downside risks. Many of these risks are related to political developments: the trade tensions between the United States and China; the Brexit issue; the rise of populism globally; and the reduced support from the United States for the liberal order that has supported the international system and contributed to a broad-based rise in living standards. One could add to this list the adjustments in China as the authorities rein in shadow financing.”
The second major “uncertainty” is household spending. While wage growth is expected to pick up in response to a tighter job market, the process is taking some time. Then there is the fall in home prices in Sydney and Melbourne. The Reserve Bank doesn’t expect households to change spending in response to changes in house prices. But they may – it is an “uncertainty”.
“Continued low income growth, together with falling housing prices, would be an unwelcome combination and would make for a softer outlook for the economy. Some Australian households have high levels of debt, so there is a degree of uncertainty about how they would respond to this combination. So we are monitoring things closely.”
The Reserve Bank Governor was at pains to point out that Sydney and Melbourne home prices are falling after a period of unbridled strength. There is also an apparent confidence that the adjustment in home prices won’t more broadly affect the job market and household spending.
“The correction in the housing market follows an extended period of strength. It is largely due to structural supply and demand factors, and is occurring against the backdrop of a robust economy and an expected pick-up in income growth. Our financial institutions are also in a strong position to deal with the adjustment. Indeed, lending standards were strengthened as the upswing went on. From this perspective, the adjustment in the housingmarket is manageable for the financial system and the economy. This adjustment will also help increase the affordability of housing for many people. Even so, given the uncertainties, we are paying very close attention to how things evolve.” What are the implications for interest rates and investors?
The Reserve Bank now acknowledges that there are risks, that if manifest, could lead to the Reserve Bank cutting rates. Much depends on household spending, home prices and the unemployment rate. And much depends on the health of the Chinese economy, especially resolution of the US-China trade dispute.
CommSec expects interest rates to remain on hold for the foreseeable future. Unemployment rate remains low and wages are rising. And whilever that situation holds, rate cuts will remain well off the radar screen. 
Published by Craig James, Chief Economist, CommSec