Renewed concern around household debt as labour market gains more confidence: Bill Evans

GUEST OBSERVER

The minutes of the monetary policy meeting of the Reserve Bank Board on August 1 show a change in the balance of risks on which the Bank is clearly focussed.

In July, the key concluding paragraph noted “developments in the labour and housing markets continued to warrant careful monitoring”.

In August, “members regarded conditions in the housing market and household balance sheets as continuing to warrant careful monitoring”.

In addition, the August minutes refer to “the need to balance risks associated with higher household debt in a low inflation environment”.

A reasonable conclusion from this change in emphasis is that the Bank is certainly more comfortable with the outlook for the labour market - “indicators of labour demand have pointed to further employment growth”, and by the end of the forecast period, “the unemployment rate was expected to be just below 5 ½ per cent, slightly lower than forecast in May”.

There was also the hint of more confidence around a lift in wage inflation, “information from liaison indicated that some employers were finding it harder to attract workers with particular skills”.

On the other hand, commentary around inflation seemed to be more downbeat.

In particular, it was pointed out that” the Australian Bureau of Statistics intends to update the weights in the CPI in the December quarter 2017 CPI release … this was expected to lead to lower reported CPI inflation because the weights of items whose prices have fallen were likely to be higher”.

The additional commentary on inflation highlights the Bank’s dilemma with regards to achieving its underlying target.

“The inflation forecast partly reflected an expectation of a modest increase in wage growth … working in the opposite direction were the effects of additional competition in the retail industry; the dampening effect of housing supply on rents; and recent exchange rate appreciation”.

While we can be extremely confident about the three latter dampening factors, the expectation of rising wages is tenuous.

Even the minutes refer to international experience where labour markets with much less spare capacity than Australia have been unable to generate wage pressures.

As discussed, the minutes highlight household balance sheets as warranting careful monitoring.

It is pointed out that housing credit growth has been growing at a much faster pace than incomes, exacerbating this imbalance.

Whereas the July minutes indicated that the impact of the macroprudential policies were yet to have their full effect, the August minutes do not continue that theme.

Commentary on the Sydney and Melbourne housing markets pointed out that conditions have eased somewhat although price growth remained relatively strong, this was despite the observation that Banks had now broadly achieved the lending guidelines around interest-only loans that were announced earlier in the year.

It was not clear that the Bank expects a further softening in house prices in Sydney and Melbourne (and an associated slowdown in credit growth) given that the regulatory guidelines had now been enacted.

Sensibly, the Bank has not tried to “jawbone” the Australian Dollar.

That can only be effective if the market believes that the Bank is prepared to take some action.

Given concerns around household balance sheets and a well-known reluctance to intervene, markets are totally confident that the Bank will not take any action to deal with the high Australian Dollar.

We saw in the Statement on Monetary Policy that despite the 3% appreciation in the TWI between May and August, the Bank chose not to adjust its growth and inflation forecasts in 2018 and 2019.

However, it now specifically states in the minutes “a further appreciation of the exchange rate would be respected to result in a slower pick-up in inflation and economic activity than currently forecast”.

It is our view that the AUD will drift back down to USD 0.76 by the time of the next forecast review (November), so the AUD will not represent a risk to the forecasts.

On the other hand, if we are wrong, we should take this comment on face value and expect an even lower forecast for inflation and economic activity.

In particular, the current inflation forecast sits at 2% for 2018, the bottom of the target band.

Most central banks would be uncomfortable forecasting a further miss in the inflation target in 2018.

Commentary around the international economy is mainly pertinent for the Bank’s China view.

In that regard, despite better than expected conditions in 2017, the Bank continues to assert that “growth in China was expected to ease in 2018 and 2019 because of structural factors such as a declining working-age population as well as policies to address financial risks”.

These minutes contained a few more surprises than we had originally expected – a clear lift in confidence around the labour market but a stronger emphasis on the risks associated with household debt.

The extensive discussion around inflation also implies less certainty around the current view that inflation will lift through 2018 and 2019.

Key to much of this discussion is around wages growth.

This will impact incomes and potential household debt ratios; inflation conditions; and the capacity of the household sector to lift its spending, thereby signalling a better environment for businesses and lifting employment and investment.

Given the evidence overseas, for countries with less spare capacity in their labour markets than Australia, we are much more cautious about the wages outlook and therefore expect that the case for higher rates next year will gradually fade.

BILL EVANS is chief economist of Westpac.