Australia markets open in 1 hour 15 minutes

Finally, the RBA is getting anxious about the housing downturn

David Scutt
* The RBA is widely expected to cut Australia's cash rate for the first time since August 2016 on Tuesday. * Markets and the vast majority of economists believe the bank will deliver a follow-up cut by September. * In the past, the first move in a RBA easing cycle has always helped to boost household confidence levels. However, when the RBA cuts again a month later, it often leads to a sharp decline in confidence levels. * That suggests aggressive rate cuts may actually concern Australians about what the future holds. * * *The Reserve Bank of Australia (RBA) is widely expected to cut Australia's cash rate for the first time since August 2016 on Tuesday.Financial markets are fully priced for a 25 basis point rate cut to be delivered. Almost every economist polled by Bloomberg also expects the cash rate to be reduced to 1.25%.By September, both markets and vast majority of economists expect a follow-up cut to be delivered, with a meaningful risk of a third cut also being priced in by the middle of next year.If correct, Australia's cash rate could be halved to just 0.75% by this time next year. A lot of policy stimulus is priced in, clearly. Given those lofty expectations, it begs the question: if the RBA intends to deliver a series of rate cuts to help stimulate the economy, why not go hard and early, potentially delivering back-to-back 25 basis point cuts both in June and July? A cash rate of 1%, after all, is already expected by September. This chart from Westpac suggests that may not be a great idea if the RBA wants to boost household confidence by delivering lower borrowing costs.Image: Westpac BankIt shows the percentage movement in the Westpac-MI Australian Consumer Sentiment Index following the 30 rate cuts the RBA has delivered since the early 1990s.When the RBA has started or resumed an easing cycle after a prolonged period, indicated by red shading, sentiment levels have always increased.However, when the bank has delivered a follow-up reduction a month after the first cut, more often than not, sentiment levels have fallen more often than not as indicated by the purple shading."Whereas the average response to ‘first moves’ is a clear positive with sentiment increasing on average by 5.6 percentage points, the response to follow on cuts is often negative, with an average decline of 3.5 percentage points," said Matthew Hassan, Senior Economist at Westpac Bank, in a note released on Monday."The latter reflects a mix of ‘cooling off’ from an initial sentiment boost and other developments."That suggests that not only does the initial sugar-hit from a first rate cut diminish quite quickly, when the RBA eases policy aggressively, it often causes Australians to become pessimistic, rather than confident, towards what the future holds.
  • The RBA's concern about Australia's housing market downturn spilling over into other parts of the economy appears to be growing.
  • At its February meeting, it noted that: "if prices were to fall much further, consumption could be weaker than forecast, which would result in lower GDP growth, higher unemployment and lower inflation than forecast".
  • The bank still regards further progress in reducing unemployment and lifting inflation as a "reasonable expectation" with steady policy settings.
  • Financial markets and an increasing number of economists disagree.

The Reserve Bank of Australia (RBA) has made it clear in recent commentary that the outlook for unemployment is crucial in terms of the next direction in Australia's cash rate.

The movements in house prices could son be added to that list.

Here's a passage from the minutes of the RBA's February monetary policy meeting explaining why:

From a longer-run perspective, members assessed that, following such large increases in housing prices, the effect of the recent price falls on overall economic activity was expected to be relatively small. However, members observed that if prices were to fall much further, consumption could be weaker than forecast, which would result in lower GDP growth, higher unemployment and lower inflation than forecast.

Clearly, after largely overlooking the risks posed by the downturn in property prices, at least according to public statements, the RBA is now acknowledging falling home prices could lead to slower economic growth, higher unemployment and a big challenge in returning inflation to the midpoint of its 2-3% inflation target.

It acknowledged that "dwelling investment was also expected to decline more sharply than previously expected, consistent with the decline in residential building approvals and the fall in housing prices".

It also noted that the slowdown in consumption seen in the September quarter, coupled with with subdued growth in retail sales in the final three months of 2018, may have been influenced by "lower housing prices and reduced housing market activity".

As such, it admitted that "uncertainty about the recent momentum of consumption and factors affecting households' future consumption decisions remained a key risk for the domestic economic outlook".

However, while the RBA is clearly alert to these risks now, it still remains optimistic that the housing market won't upend the broader economy, nor warrants lower official interest rates as yet.

"Given that further progress in reducing unemployment and lifting inflation was a reasonable expectation, members agreed that there was not a strong case for a near-term adjustment in monetary policy," the key final paragraph of the minutes read.

"Rather... it would be appropriate to hold the cash rate steady and for the Bank to be a source of stability and confidence while further progress unfolds."

Given the recent trajectory of some Australian economic data, financial markets are clearly not sure that stability is required, nor helping to build confidence, continuing to price in a full 25 basis point rate cut from the RBA by the middle of next year. A small but increasing group of market economists also share this view.

Upcoming economic data will go a long way to determining what will happen next with the cash rate.

Given the RBA's nod in the February minutes, housing data looks set to play a prominent role.

NOW READ: The RBA is a serial offender when it comes to overestimating Australian GDP and inflation