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Will rate rises happen soon?

David Bassanese
Wednesday, November 22, 2017

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By David Bassanese

Slowly but surely, the Reserve Bank appears to be paving the way for a lift in interest rates in the second half of 2018. In an important speech delivered in Sydney overnight, RBA Governor Philip Lowe spelt out in detail why our cherished central bank is feeling more confident about the economic outlook, and more willing to again suggest “it is more likely that the next move in interest rates will be up, rather than down.”

I also share the RBA’s optimism to some degree, but I also suspect its forecasts – or at least its “central scenario” still remains more hope than reality. My central scenario is that economic growth will remain sub-3% over the coming year and wages and inflation are likely to remain stubbornly low.

Under this view, it’s still hard to see the RBA raising rates for a good deal longer.

First the good news. After several years of decline, there is light at the end of the dark tunnel with regard to the slump in mining investment. As the Governor indicated, the “wind-down of mining investment is now all but complete”. Associated with this, economic conditions in the mining states of Western Australia and Queensland appear to have bottomed, with employment rising through much of the past year.

What’s more, there’s also tentative signs of a lift in non-mining investment. This is being supported by an infrastructure boom and ongoing growth in service sectors such as health, education and tourism.

That said, the big drag on growth remains weakness in wages and household income, which in turn has meant consumer spending remains quite soft. Indeed, Lowe was not shy in revealing how hopelessly wrong the RBA has been with regard to consumer spending, as the chart below demonstrates

Undaunted, the RBA’s hope is that the gathering strength in business investment and ongoing growth in employment will eventually lead to a lift in wages growth and consumer spending – a nice positive feedback loop, were it to occur.

And there appear tentative signs that this is happening! According to Lowe “we are hearing reports through our liaison program that in some pockets the stronger demand for workers is starting to push wages up a bit.”

Yes that’s right – wage are rising a “bit”, and in “some” sectors.

While it’s nice to be hopeful, what Lowe did not mention was that housing activity appears to have peaked earlier than the RBA expected – and this handy source of growth and employment will go missing in action in 2018. Consumer spending in Sydney and Melbourne is also increasingly vulnerable as house prices eventually turn. Recent auction clearance rates already suggest Sydney house prices are now falling.

And as the RBA also readily admits, there also remains considerable spare capacity in the overall labour market – and, as most evident in the United States, wage growth still remains dormant in countries with labour markets much tighter than our own.

While business might respond to some pockets of labour tightness by bidding up wages, there’s also a good chance they’ll react by focusing on improved productivity through labour saving investments instead. After all, companies face intense pricing pressure also, and Amazon’s attack on local business is only just getting started.

Of course, while cost cutting – due to both competitive imperatives and technological opportunities - makes sense for an individual firm, at the national level it can become self-defeating if to leads to weak household income and consumer spending (and more broadly rising income inequality).

This is the quandary Australia and much of the world now faces, and it’s why there’s a growing dichotomy between business and consumer sentiment.

For investors at least, the good news is that persistent low inflation and low interest rates means every dollar that a business is able to earn is cherished more highly – which is why share market valuations are likely to continue to push higher for some time yet. But for those getting excited about a rate rise sometime soon – I would not hold my breath.

Published: Wednesday, November 22, 2017

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