Australia: Walking the tightrope

There's a new movie out called The Walk about Phillippe Petit's morning stroll between the Twin Towers of the World Trade Centre in New York on a high wire. Apparently, the movie is so well filmed that it gives the audience vertigo. I'm sure that members of the Reserve Bank of Australia sometimes feel like they are walking the tightrope as they try to find that balance point for the economy and interest rates.

Writing ahead of the RBA's November meeting, the decision to cut the current 2 per cent policy rate to another historical low is finely poised and as of 30 October, markets were pretty mixed regarding a rate cut, pricing in a 49 per cent probability of a reduction to the official policy rate. The knife-edge decision reflects that there are some balancing forces in play within the economy which are acting to offset falling commodity prices and a decline in mining investment. Even so, were the RBA to remain on hold in November, there would still be the opportunity for further rate cuts this year and into 2016 if it starts to be buffeted by these headwinds. Policy setters will be trying to judge whether the pick-up in domestic demand and the slow grind away from the mining sector are enough to offset global weakness and the potential for another Chinese growth scare.

The global economy suffered a significant loss of momentum during 2015 which was largely centred in the emerging world, with the fallout impacting developed markets in various ways. Commodity exporters will find themselves at the thinner end of the wedge; meanwhile, the more advanced economies will be looking toward domestic demand to offset global weakness.

In some respects, Australia – and Canada – could be considered as "emerging market proxies" given their heavy dependence on commodity exports, and that growth forecasts for both countries have been cut – Canada's more so than Australia. The latest IMF projections reduced 2015 GDP growth estimates for Australia only slightly, to 2.4 per cent, to reflect the impact of lower commodity prices and decline in resource-related investment. Although Australia has coped relatively well so far during the current commodity downturn – at least compared to Canada – there are several factors which will constrain growth and keep policy setters at the RBA on their toes.

The housing market is always a hot topic when it comes to the outlook for interest rates. Wouldn't further interest rate cuts simply fan the flames of an already overheated housing market? Shouldn't the central bank cut rates to offset the recent tightening by the big four banks?

The buoyancy of housing has helped to smooth the gradual economic reorientation from mining to non-mining as a source of growth, but concerns on the frothiness are certainly well justified. It could be argued that the use of macroprudential rules as a means to take the sting out of the housing market without reducing lending to the rest of the economy are showing signs of success. Perhaps what the RBA had not expected was the move to increase credit standards and rates on loans for both owner-occupiers as well as investors. Many countries are struggling with booming housing markets and policies are typically designed to reduce the activities of speculators. The risk is that the housing market cools too quickly, undermining the one area that has been providing support to the economy and creating a positive wealth affect for households.

Perhaps the most surprising aspect of the economy has been the resilience of the labour market. The rotation away from capital-intensive mining and towards the more labour-intensive service sectors has helped to keep the lid on the unemployment rate. This rotation has been aided by the fall in the Aussie dollar. The dollar has weakened significantly over the last year, falling 20 per cent in the 12 months to the end of October. The weaker currency has provided some boost to how companies see the current climate as reflected in the condition index of business surveys, particularly in the services and tourism industries.

Even with the substantial decline in the currency, the RBA would no doubt like to see it move a little lower. However, for one currency to weaken another must get stronger, and the actions of other central banks may have a greater role to play on how the Aussie dollar moves and potentially unwind some of the good work of the weaker currency.
The statement accompanying the US Federal Reserve's October meeting was slightly less-dovish than expected as the policy setters kept the door wide open for a December rate hike despite weaker economic data. 'Fedspeak' continues to centre on a possible rate hike in 2015, but this is not guaranteed and the hurdle for the Fed to keep rates on hold at its December meeting is pretty low given the concerns about the health of both the US and global economies.

Meanwhile, the European Central Bank has almost ensured that it will expand, or at the very least extend, its currency quantitative easing strategy come December and there is every chance that the Bank of Japan will find itself doing more to stimulate economic growth. Any moves to delay tightening of policy rates in the US or to ease policy further elsewhere could create upward pressures on the Aussie dollar.

The weaker than expected inflation figures for the third quarter certainly lowered the bar for a move by the RBA and the numbers would have to be much higher in the fourth quarter to meet the RBA's projection of 2.5 per cent inflation for this year. Given the persistent weakness in commodity prices this is unlikely to happen. The RBA's preferred measures of the "trimmed mean" and "weighted median" now sit at 2.1 per cent and 2.2 per cent respectively, right at the bottom of the policy target range of 2 to 3 per cent. The weaker dollar will push inflation higher in the future as the price of imports rises, but this will do little to change underlying inflation in the domestic economy, which is the greater concern.

Other commodity exporting countries have found themselves falling into recession or suffering from seriously weak economic growth. The policy response from central banks has been to cut interest rates to near zero. Australia has so far managed to avoid this scenario, and at present there seems to be enough momentum in the economy and support from the weaker currency to see the economy through a period of slower growth. However, the risks are all on the downside and the RBA will be keeping a close eye on the currency, the housing market as well as the strength in the global economy as well as the actions of other central banks to ensure they and the economy don't slip from the high wire.

Kerry Craig is a global market strategist with JP Morgan Asset Management.