Industry Focus

Australian interest rates MATTHEW HASSAN, SENIOR ECONOMIST Our dominant theme in this cycle has been that a weak labour market would undermine consumer spending, which in turn constrains investment, employment and incomes. Businesses react negatively to soft demand; an uncertain global environment and a "still high" AUD. Those forces are expected to be complemented by a number of known headwinds— mining slowdown; fiscal restraint; falling terms of trade and a resilient AUD as global growth, including in the US, disappoints. While headwinds persist ... Westpac has revised its profile for the RBA cash rate in 2014. Previously we expected that rates would be reduced by 25bps in both August and November. The forecast is now for flat rates throughout 2014. As before we do not forecast a rate hike until the third quarter of 2015 with a 25bp hike in both the September and December quarters. We now expect the RBA to be on hold in 2014. We have been impressed by the momentum in household spending in the final quarter of 2013 (up 0.8% real); the upward revision in spending growth in Q3 from 0.4% to 0.7%; and the surprising 1.2% print for retail sales growth in January. That momentum is partly associated with the lift in Consumer Sentiment to a peak of 110 in November last year. The recent drop in the Index to 100 is indicating a slowing in that momentum in the second quarter but not to a pace that would, of its own, trigger a rate cut. Dwelling approvals have lifted markedly. They are now up by 35% over the year to January 2014, indicating a solid lift to residential building in 2014. We have always anticipated that lift to construction activity but had expected that the slowdown in the momentum in overall consumer spending would largely offset that boost. With consumer spending momentum holding up better than expected that offset is now seen to be less significant. In preliminary calculations we have raised our forecast for headline inflation in the March quarter 2014 from 0.6% to 0.7%. At this stage we retain our call for the core inflation print of 0.6% but recognise that the risks on the core are now to the upside. Note that the Reserve Bank's implied forecast for core inflation in the March quarter appears to be 0.8%, with the assumption that the pass through from the fall in the AUD in 2013 will take longer to work through than just in the December quarter 2013. If the Reserve Bank's forecast is correct then rate cuts would be firmly off the table. Growth in housing finance has been very strong, up 26.9% for the year to December and 22.3% for the year to January. Within that, loans to investors slowed from 40% (in December) to 28.6% in January. Owner-occupiers slowed from 19.4% (December) to 18.6% (January). The "time to buy a dwelling" index from the Westpac Melbourne Institute Consumer Sentiment Survey is down by 16.8% from its September peak. There are tentative signs that housing lending might be slowing. As discussed, that slowdown, which has always been core to our forecasts, appears to be evolving. However, such a slowdown was a necessary but not sufficient condition for lower rates. The Westpac Melbourne Institute Index of Unemployment Expectations has reached a five-year high. Households are nervous about their job security and that is likely to weigh on household spending going forward providing further support for a "soft spot" in consumer spending in the June and September quarters. That is likely to keep rates on hold, although more positive trends in the labour market are likely to see that "soft spot" insufficiently threatening to warrant a rate cut. ... has the RBA on the sidelines. Although a pull- back in sentiment in early 2014 ... ... points to some loss of momentum. Rate hikes unlikely until 2nd half of 2015. The upward revisions to the current state of the labour market as indicated by the February jobs report where jobs growth in February was reported as 47,300 (80,500 full-time) and January was revised up from -3700 to 18,000 painted a much more normal picture of the Australian jobs market. That meant that the dismal start to 2014 of -10,400 in the previous three months was revised to a modest but respectable 41,000 over the three months to February. We accept that there were probably sampling issues with this report but that revised picture of the labour market now seems more consistent with recent lead indicators of employment intentions in the business surveys (which have recently lifted). It is true that the unemployment rate was unchanged at 6% and we still expect that the unemployment rate will increase from this point to reach about 6.5% by year's end. However, whereas before we saw the risks to that forecast to the upside they are now tilted to the downside. ... as well as employment and business confidence ... We still see those forces operating to moderate growth and inflation pressures but now assess that better news on employment; consumption; and business confidence will dampen those contractionary forces to exclude a sufficiently strong case to cut rates. This is in the context of a high hurdle from the perspective of the Reserve Bank to further cutting rates. Equally, however, there will be no case for higher rates for 18 months or more. Details behind this view change are set out below. ... better news on consumption and housing ... REAL ESTATE SERVICES 12 Industry Focus

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