Benign outlook for growth and inflation: Westpac's Bill Evans

Benign outlook for growth and inflation: Westpac's Bill Evans
Benign outlook for growth and inflation: Westpac's Bill Evans

GUEST OBSERVER

World interest rates are currently very low. Market expectations for future interest rate movements are also remarkably benign.

If we look at the forward swap curves for US and Australia we note the following profiles:

US: Current Federal Funds Rate is 0.12% and markets expect the rate to be 0.61% in one year’s time.

Over the following years markets expect the Federal funds rate to average: 0.9% in the year to September 2017; 1.4% in the year to September 2018; and 1.8% in the year to September 2019.

Australia: Current RBA cash rate is 2.0% and markets expect that rate to be 1.75% in one year’s time.

Over the following years markets expect the RBA cash rate to average 1.8% in the year to September 2017; 2.0% in the year to September 2018; and 2.4% in the year to 2019.

The question is whether these extremely benign expectations are realistic.

For the US for instance these market expectations imply that even over the next 4 years, when inflation is expected to “settle” at around 2%, real interest rates will still be negative.

Real interest rates are also expected to be negative over that period in Australia with inflation reasonably expected to average around 2.5% - the middle of the RBA’s target 2-3% zone.

How does this outlook compare with the pre-GFC period in the US?

Taking a starting date of 1985, when US inflation had moved towards a more normal range, we note that the FEDERAL FUNDS Rate averaged 5.1% and the 10 year bond rate averaged 6.4%.

Over that period economic growth averaged around 3.2% and inflation around 2.5%. A reasonable “rule of thumb” is for bond rates to reflect the sum of economic growth and inflation. We accept that the “theoretical bond rate is the sum of the real cash rate; expected inflation and the term premium although we would expect that the term premium should be related to an expected growth concept.

With the equilibrium margin between bond rates and the cash rate at around 1.5% the current market expectation for bond rates over the 4 years to September 2019 is around 3% (cash rate averaging around 1.5%).

Most forecasters for the US economy would expect growth to average around 2% and inflation around the same. That suggests that current market pricing for rates is probably too “low”, even given the more subdued outlook for growth and inflation since the GFC.

How does this compare for Australia?

If we take a comparable post boom inflation period for Australia: 1993 – 2007 we note that average GDP growth was 3.7% while inflation averaged 2.6%. The 10 year bond rate averaged 6.5% and the RBA cash rate averaged 5.6%. That “rule of thumb” with growth and inflation broadly in line with bond rates also held for Australia during that period.

The equilibrium margin between the cash rate and the bond rate was around 1% - lower than in the US.

The Forward Curves are pricing in much lower interest rates post GFC than pre-GFC.

Is it indeed reasonable to assume a much more subdued outlook for growth and inflation post GFC?

I believe that the answer is a qualified “yes” mainly due to the headwinds which developed economies are now facing on the demand side as a result of the build -up in private and public sector debt since the GFC.

Consider the US: between December 2003 and December 2007 household debt ballooned from USD 9012 trillion to USD 13228 trillion (up nearly 50% in 4 years). Despite significant write-offs US household debt remains at USD 12692 trillion – limited progress has been made in rewinding the debt. Households are cautious, unwilling to take on more debt – that behaviour blunts the effect of low rates, constrains growth, and widens negative output gaps.

Similarly US government debt has ballooned from USD 7959 trillion in late 2007 to USD 16049 trillion by end June 2015. Governments are a drag on growth constantly seeking to repair fiscal damage – this effect is also likely to continue well beyond even the 4 year period we are considering with the yield curves.

In the case of Australia, gross household debt ballooned from 100% of disposable income in 2000 to 153% by the beginning
of the GFC. Households have been able to stabilise this ratio at 155% of disposable income but have had no success in being able to reduce the ratio.

However, we have seen how these debt levels have muted the impact of the RBA’s rate cuts with households generally choosing to use any cash flow improvements to pay down debt rather than boost spending.

Although Australian corporates have generally low gearing they have behaved as if they are in a debt minimising world rather than necessarily profit maximising. Prior to the GFC non mining investment averaged around 13.5% of GDP. That ratio fell sharply to around 10.5% and has remained stubbornly around that level ever since. 

Government debt levels have constrained both state and Federal governments. Net government (including both state and Federal) debt has risen from -1.2% of GDP in 2007/08 to 27% of GDP in 2014/15.

Policies to address fiscal fragility have impacted government’s scope to boost growth on the demand side.

Equally we might address the growth outlook from the supply side. Political difficulties associated with the debt levels have constrained government’s scope to embrace the reform needed to boost productivity while the weak demand conditions tempt governments to slow down immigration impacting on the future growth in the workforce.

Similarly firms’ fixation with debt and associated cautious approach to investment will also detract from boosting productivity.

So do these more subdued growth and inflation outlooks post GFC justify current market pricing?

The answer is a qualified “no”.

US pricing implies a bond rate in equilibrium of around 3% whereas, even in a post GFC world, growth (2%) and inflation (2%) implies a bond rate of around 4% rather than 3%.

For Australia, pricing indicates an equilibrium bond rate of around 4.0% whereas inflation (2.5%) and growth (2.5%) would imply a bond rate much nearer to 5%.

Conclusion

Markets are pricing in an incredibly benign outlook for interest rates. There are good reasons associated with the pre and post GFC build up in debt levels that justify a lower growth and inflation outlook.

But markets have gone too far with these assessments and implied bond and cash rates look to be around 1% lower over the next 4-5 years than economic fundamentals would imply.

BILL EVANS is chief economist of Westpac.

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Interest Rates

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