The current cold, dark and wet days of the northern hemisphere winter are in direct contrast to the balmy summer days being enjoyed by the antipodeans. This is especially so for the Reserve Bank of Australia (RBA), where base rates are now unchanged for the past 17 months (Fig 1a). With no RBA meeting scheduled for January 2018, and the central bank unlikely to change rates for the foreseeable future, base rates will soon be unchanged for a record period of time. The confluence of several local and international trends has created this impasse – an unusual state for such an activist central bank, which has moved rates almost three times as frequently (Fig 1b) as the Fed over the past decade.
Historically, Australia’s economic strength was based on commodities and domestic demand – allowing the country to successfully weather both the Asian Financial Crisis and the Global Financial Crisis. With the economy currently enjoying its 26th year of expansion, the RBA remains confident that GDP will continue to increase modestly next year. The current growth rate is predicated on record low interest rates which have stimulated a potentially unsustainable housing boom (Fig 2a) and a recent recovery in commodity exports which is dependent on continued Chinese growth. However, these factors mask the underlying challenges of high consumer debt, muted wage growth (Fig 2b) and weak consumer sentiment – which in turn have locked the RBA into a policy dilemma.
A decade of strong population growth and foreign investor demand combined with record low mortgage rates (especially on popular interest only mortgages) has pushed dwelling construction, sales and prices to record highs. However, reduced affordability, slower net migration and tighter lending standards have recently reduced home sales and demand for home loans, leaving prices precariously high.
Australian employment has been strong with annual job creation hitting a twenty year high of 383,000, while the unemployment rate remains subdued at 5.4%. But this strength has not boosted consumer confidence nor triggered wage growth which has recently fallen to a record low of 1.9%y/y. Combined with muted inflation and record household debt-to-income levels of 194%, consumer finances are strained.
So should the RBA cut or hike rates? Investors remain indecisive, with Bank Bill Swap (BBSW) rates (Fig 3a) and forwards (Fig 3b) vacillating between cuts and hikes over the past several months.
Muted economic growth and inflation below target suggest the RBA should cut rates further. But this risks further inflating the housing bubble and debt burdens while doing little to stimulate wage growth; especially if (as the RBA governor believes) the Phillips curve has flattened.
Meanwhile, improving global and domestic growth, combined with robust employment and asset price inflation, suggests the RBA should hike rates. But this risks sparking a collapse in housing prices, a sharp increase in consumer debt servicing costs and a stronger currency.
Neither scenario appears palatable, so despite current market and broker expectation for further hikes in 2018, it is very likely the RBA decides the best course of action is to keep rates unchanged and basks in the lazy days of summer for the foreseeable future.