Expect ongoing emphasis on housing risks: Westpac's BIll Evans

GUEST OBSERVER

This will be the traditional Board meeting being held one week before the Commonwealth Budget on May 9.

The Board is certain to hold rates steady.

In fact Westpac has argued consistently since May last year that, after an expected cut in August 2016, rates would be held steady for the remainder of 2016 and 2017.

Earlier this year we extended that view with the expectation that the Bank would also hold rates steady through 2018. 

In the minutes to the April Board meeting the Bank surprised somewhat by emphasising the importance of the major competing forces on rates: “The Board judged that developments in the labour and housing markets warranted careful monitoring over coming months.”

Since that statement key news items have been around the employment report and the inflation report.

The employment report for March printed much stronger than expected – 60,900 jobs added including a 74,500 rise in full time jobs. However the unemployment rate remained at 5.9 percent – well above the 5.0 percent level accepted as 'full employment'.

That theme of excess capacity was prominent in the March inflation report. The report was highlighted by falling prices for clothing & footwear; household contents & services; cars; audio visual & computing; and international travel. Underlying inflation rose just 0.4 percent for an annual pace of 1.8 percent.

Overall, while the employment report may have been somewhat welcome to the spectre of spare capacity in the economy weighing on inflation; labour markets and wages would still be a concern for the authorities.

The situation around housing markets is more unclear with uncertainty around the impact of new macro prudential policies – a 30 percent cap on the proportion of new loans that are 'interest only' (currently 62 percent of investor loans and 23 percent of owner occupier loans are interest only).

The last time macro prudential policies were adopted, in 2015, they were very successful in slowing house price growth. These earlier measures included slowing annual growth in investor housing credit to a 10 percent target and were complemented by an effective increase in the mortgage rate of 27bps. Sydney dwelling price inflation slowed from 20 percent to 0 percent (on a 6mth annualised basis) while Melbourne prices slowed from 14 percent to 5 percent. This impact was curtailed by the May and August rate cuts in 2016.

Arguably the Board might regret those cuts given the resurgence in house price growth through the second half of 2016 and 2017.

Our call for steady rates assumes the persistence of the excess capacity in goods; services; and labour markets as exemplified in recent data releases without any threatening collapse in house prices – rather a gradual slow down through the remainder of 2017 and 2018. A sharp retraction along the lines of 2016 is still highly unlikely to draw further rate cuts from the Bank given the experience of 2016/17.

Our major interest will be in the growth and inflation forecasts along with some more colour to the risks.

Key growth forecasts in the February SoMP were: GDP growth in calendar 2017: 2.5 percent -3.5 percent; GDP growth in calendar 2018: 2.75 percent- 3.75 percent.

We believe the Bank will see growth prospects as unchanged since February although there may be a 'one off' adjustment for the impact of cyclone Debbie in the June quarter (some official estimates of a 0.25 percent 'hit' have been mentioned).

Of more importance will be the 3.25 percent (mid- point) forecast for 2018. Westpac is surprised at the Bank's persistent optimism. We expect the housing construction cycle to have clearly 'rolled over' by then with the terms of trade also in retreat. We expect growth in 2018 of around 2.5 percent.

Other factors that are also likely to weigh on growth in 2018 are the impact on business and household balance sheets of high energy prices, and intensifying political uncertainty. A lower AUD will contribute a welcome offset (USD 0.65 'target' in 2018).

The IMF recently released upward revised growth forecasts for Australia – 3 percent in 2017 and 3 percent in 2018 (year average measures). The 2017 forecast is higher than the RBA’s year average forecast of 2.5 percent but we expect the Bank to hold its forecasts steady. 

We do, however, expect that the Government will adopt a higher growth forecast in the May 9 Budget, raising the 2017-18 financial year number from 2.75 percent to 3 percent, in line with the IMF.

Inflation forecasts are also expected to be unchanged: current underlying inflation is running at 1.8 percent annual. RBA forecasts are 1.5-2.5 percent in both 2017 and 2018. These forecasts are 0.5 percent below the target 2-3 percent but not sufficiently awry to demand a policy change, particularly since the forecast to June 2019 indicates a return to the 2-3 percent target band.

Underlying assumptions around the AUD are also unlikely to warrant any forecast changes with the February forecasts using USD 0.76 compared to the likely USD 0.75 in the May forecasts. 

In the February SoMP the discussion on 'housing risks' centred on the downside: "history shows that sentiment can turn quickly.” Of course prices have continued to boom in the interim – we expect ongoing nervousness in the May SoMP emphasising the risks associated with a further intensification of macro prudential controls.

BILL EVANS is chief economist of Westpac.