RBA on hold as the falling AUD supports growth: HSBC's Paul Bloxham

RBA on hold as the falling AUD supports growth: HSBC's Paul Bloxham
RBA on hold as the falling AUD supports growth: HSBC's Paul Bloxham

GUEST OBSERVER

Currency depreciations may not work for every country, but the lower AUD is already providing clear support for Australia's growth (and inflation).

Services exports, including tourism and education exports, have picked up and the lower currency is also beginning to discourage services imports. Net services exports have contributed more to GDP growth over the past year than resources exports, in a clear sign that the lower AUD is working. More broadly, business conditions and jobs growth have picked up, as very low interest rates and the lower AUD support growth.

For quite some time, the central bank had been concerned that Australia would not be able to head back to a balanced growth path with low interest rates alone and that it would require the AUD to fall. In the past three months it has fallen 6% in trade-weighted terms and is now at a level with which the RBA is comfortable. In recent testimony, RBA Governor, Glenn Stevens, noted that 'you would be hard pressed to say [the AUD] was seriously misaligned at the moment'. Comparing the AUD to the level of commodity prices suggests that around US68-70 cents is currently approximately 'fair value'.

Modelling also shows that the falling currency should be a strong support for growth, with much of the effect still to come. Recent published work from the RBA suggests that the decline in the exchange rate over the past year (15% in trade-weighted terms) should be expected to lift GDP by 0.4-0.9% over 1-2 years, if it's temporary, and by 1.0-1.4% over 2-3 years, if it's permanent. These are big numbers.

With the AUD doing the work for them, we expect the RBA to be reluctant to cut rates further, despite the slowdown in China and the recent delay to the Federal Reserve's interest rate 'lift off'. Indeed, a key question the central bank is now likely to be asking is: would further rate cuts provide more benefits than costs? To a large degree this question is: would the RBA want to boost housing prices and construction further at this point in the cycle? We suspect not and expect the RBA to be on hold in coming quarters. 

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RBA on hold as the falling AUD supports growth: HSBC's Paul Bloxham

Looser policy is now coming through a lower AUD

The AUD has now fallen to a level at which it is providing significant support for the rebalancing of growth. Indeed, having fallen by 9% in the past three months the AUD (against the USD) is now around a level that is consistent with the fall in commodity prices that has occurred, which is part of the reason the RBA is no longer publicly suggesting that it expects or needs the currency to fall further (Chart 1).

The combination of low interest rates and the lower AUD is lifting domestic economic activity. Employment growth has picked up to 2.0% y-o-y and business conditions have been improving (Chart 2). The positive effect of low interest rates and the lower AUD is also likely to have further to run, particularly as the AUD has declined sharply in just the past three months.

There is also clear evidence in the trade statistics that the lower AUD is supporting growth. Exports of services, including tourism and education services, are picking up and growth in imports of services is also slowing down. Net services exports have contributed more to GDP growth over the past year than resources exports, although resource exports are still positive (Chart 3)

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RBA on hold as the falling AUD supports growth: HSBC's Paul Bloxham

 

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RBA on hold as the falling AUD supports growth: HSBC's Paul Bloxham

A solid lift in the non-mining sectors of the economy is needed, as the fall in mining investment is still only part way done. Mining investment is set to fall again in 2016, before it may start to stabilise in 2017 (Chart 4). We expect the fall in mining investment to be more than offset by the pick-up in exports and the non-mining sectors of the economy, allowing growth to gradually lift over coming quarters.

Costs of another rate cut could outweigh the benefits

Nonetheless, the market is looking for more possible rate cuts. In this regard, a key question the central bank is now likely to be asking is: would further rate cuts provide more benefits than costs? Would the RBA really want to boost housing prices and construction further at this point in the cycle? Although the effect of interest rates is not only on the housing market – they affect asset prices, household cash flows and businesses' costs of capital, among other things – the strongest impact is on housing sector activity.

Indeed, a key driver of the rebalancing of Australia's growth, as mining investment has fallen, has been a pick-up in housing construction, motivated by low interest rates and rising housing prices. This has mostly been a positive story because Australia did not build many houses during the mining boom and had an accumulated undersupply of dwellings.

But the recent ramp up in housing construction combined with slower population growth means that the cumulative housing deficit is diminishing (Chart 5). On our estimates, based on building approvals remaining around their current levels into next year, the housing market could be in balance by 2017. At a state level we see the biggest risk of over-supply in Victoria, which is already close to balance, while NSW and Queensland are likely to have undersupplies for quite some time yet.

Further rate cuts could therefore risk both over-inflating housing prices, particularly in Sydney where they have already risen by 50% over the past three and a half years and potentially driving an over-supply of dwellings (Chart 6). In short, the costs of cutting interest rates further may outweigh the benefits. It may be better to hold steady on rates and allow the exchange rate to rebalance growth towards the exchange-rate sensitive industries, as it already appears to be doing. 

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RBA on hold as the falling AUD supports growth: HSBC's Paul Bloxham

 

RBA tactics and commentary

As we have argued above, the RBA is likely to see the recent fall in the AUD as a further loosening of financial conditions that should preclude the need for further interest rate cuts at this stage. We have also argued that the central bank will be reluctant to cut interest rates any further because of the risks of overinflating the housing market or potentially causing an eventual over-supply of housing.

In the RBA's figuring, we expect global developments to play a role. On-going concern about the slowdown in China is a risk for the local growth outlook, although we note that the RBA has been expecting China's growth to slow for some time. The RBA is likely to also hope that the Federal Reserve raises rates before the end of the year, as this would help maintain downward pressure on the AUD. We expect the commentary from the RBA to flag these global risks, but to be fairly neutral on the local economy.

Finally, in terms of the medium-term outlook for policy, watching out for the Q3 CPI print, which is due to be published on 28 October, will be important. Underlying inflation has remained within the RBA's target band, albeit in the lower half (Chart 7). We expect a solid underlying inflation print in Q3, partly supported by the impact of the lower currency (Chart 8). The y-o-y rate is also likely to get additional support as the effect of the removal of the carbon tax (which held down inflation in Q3 and Q4 2014) largely drops out of the annual numbers. On our estimates, this effect is likely to add around 0.1-0.2ppts to the y-o-y underlying rate of inflation.

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RBA on hold as the falling AUD supports growth: HSBC's Paul Bloxham

 

PAUL BLOXHAM IS CHIEF ECONOMIST (AUSTRALIA AND NEW ZEALAND) FOR HSBC. 

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