RBA Minutes, More of the Same

The RBA released the minutes from their last meeting.  Once again low wage growth, and household debt figured in the discussion, as did a focus on financial stability and the role of prudential supervision.

Members discussed how financial stability considerations bear on monetary policy decisions, reviewing both the academic literature and policy experience in a number of countries, including Sweden and the United States.

The Bank has responsibility for promoting financial stability within its flexible medium-term inflation targeting framework. Over recent times, with interest rates at low levels, the Board has set monetary policy to support the economy in its transition following the mining investment boom, while also paying close attention to trends in household borrowing and related financial stability considerations. Members discussed the effect of monetary policy decisions on financial stability and on future inflation, employment and output. They also discussed the role that prudential supervision can play in promoting financial stability. In view of this, members acknowledged the importance of a strong relationship between the Bank and other regulators, particularly APRA. They observed that the current positive culture of cooperation across the relevant agencies in Australia has been of considerable value to good policy outcomes in recent years and it is therefore important that it be maintained. The strong relationship among regulators is facilitated by the Council of Financial Regulators, which is the coordinating body for the main financial regulatory agencies to promote the stability of the Australian financial system, as well as contribute to the efficiency and effectiveness of financial regulation.

Turning to the immediate decision regarding the level of the cash rate, members noted that the broad-based pick-up in the world economy was continuing. Labour markets had tightened further in many countries and this was expected to lead to a pick-up in wages and prices over time. Headline inflation rates in most countries had moved higher over the past year, partly reflecting higher commodity prices. Nonetheless, core inflation had remained low.

Domestically, members’ assessment was that the transition to lower levels of mining investment following the mining investment boom was almost complete. Surveyed business conditions had improved and business investment had picked up in those parts of the economy not directly affected by the decline in mining investment. Although year-ended GDP growth was expected to have slowed in the March quarter, reflecting the quarter-to-quarter variation in the figures, members noted that economic growth was still expected to increase gradually over the next couple of years to a little above 3 per cent per annum.

Members noted that, although employment growth had been stronger in recent months, growth in total hours worked had declined. Nevertheless, the various forward-looking indicators pointed to continued growth in employment over the period ahead and a gradual erosion of the spare capacity in the labour market. Wage growth had remained low and this was likely to remain the case for some time yet. However, wage growth and inflation were expected to increase gradually as the economy strengthened. Members observed that low growth in incomes, along with high levels of household debt, appeared to have been restraining growth in household consumption.

The economic outlook continued to be supported by the low level of interest rates. The depreciation of the exchange rate since 2013 had also assisted the economy in its transition following the mining investment boom. An appreciating exchange rate would complicate this adjustment.

Conditions in the housing market had continued to vary considerably around the country. Housing prices had been rising briskly in some markets, although there had been some signs that price pressures were starting to ease. In the eastern capital cities, a considerable additional supply of apartments is scheduled to come on stream over the next couple of years. Growth in housing debt had outpaced the slow growth in household incomes. APRA’s recent prudential supervision measures should help address the risks associated with high and rising levels of indebtedness. In response to those measures, increases in mortgage rates, particularly for investors and interest-only loans, had been announced, but were yet to have their full effect.

The Board continued to judge that developments in the labour and housing markets warranted careful monitoring. Taking into account all the available information, including that year-ended growth in output was expected to have slowed in the March quarter, the Board judged that holding the accommodative stance of monetary policy unchanged at this meeting would be consistent with sustainable growth in the economy and achieving the inflation target over time.

Australia is facing an interest rates dilemma

From The Conversation.

This week the US Federal Reserve, as expected, raised its benchmark interest rate by 25 basis points, to a range of 1-1.25%. This was the third such hike in the last six months.

Fed Chair Janet Yellen said:

Our decision reflects the progress the economy has made and is expected to make.

Yet not everyone was so jazzed about the decision. In a terrific piece former US Treasury Secretary Larry Summers articulated “5 reasons why the Fed may be making a mistake”.

And whether the Fed view or the Summers view is the better one has tremendously important implications for what the Reserve Bank should do here in Australia.

The nub of Summers’s concern revolves around the implicit model of the economy that the Fed is using – and whether it still works in the economic world in which we find ourselves.

The general worry with keeping rates too low, for too long, is that inflation will take off. In the past, policymakers have worried – with good reason – that waiting to raise rates until inflation starts rising much is dangerous because it can get out of control.

If one is not going to wait to see what happens to inflation, then one needs a way to predict the path of it. The traditional approach that policymakers have taken is to look at the relationship between unemployment and inflation – the so-called Phillips Curve – and predict future inflation based on unemployment.

Summers prefers what he calls the “shoot only when you see the whites of the eyes of inflation” paradigm. This – as the imagery suggests – involves waiting until the last possible point before raising rates. In other words, be really sure that the inflation is happening.

This makes sense if the old model is broken, and Summers makes a persuasive case that it is.

First, he points out that the Phillips Curve (the allegedly stable relationship) may not even exist. And even if it did, scholars have pointed out that it would be very hard to estimate statistically the Goldilocks point where unemployment is such that the rate of inflation is stable (the so-called Non-Accelerating Inflation Rate of Unemployment or NAIRU).

Second, Summers offers a different model of the world – at least in part. That model is one where advanced economies – like the US and Australia – are suffering from “secular stagnation”.

According to Summers, the implication for monetary policy of this are as follows:

there is good reason to believe that a given level of rates is much less expansionary than it used to be given the structural forces operating to raise saving propensities and reduce investment propensities.

I am not sure that a 2 percent funds rate is especially expansionary in the current environment.

Moreover, he sees asymmetric risk with getting it wrong, going on to say:

And I am confident that if the Fed errs and tips the economy into recession the consequences will be very serious given that the zero lower bound on interest rates or perhaps a slightly negative rate will not allow the normal countercyclical response.

Maybe the combination of a fire hose of global savings chasing too few productive investment opportunities has changed what level of interest rate can provide a serious boost to economic activity.

Which bring us to Australia. We, too, have relatively low unemployment by historical standards (the ABS just announced a drop in May to 5.5%), yet wage growth is remarkably low. Those two things happening together suggests that our old understanding of the labour market is off the mark. That low wage growth is a major driver of the low inflation we are also experiencing.

If Summers is right, and there isn’t some big point of difference between Australia and the US in this regard, then the unmistakable implication is that the RBA should probably cut rates – perhaps twice – later this year.

But there is that whole housing price thing in Australia. A rate cut could fuel further price rises which, as bad as that is for affordability, is also deeply problematic for financial stability.

Yet, if the Australian economy really does need a rate cut, and governor Philip Lowe holds steady because of housing price fears, then that could trigger a further slowing of GDP growth, put wages under even more pressure, and trigger a recession itself. And that would be bad news for financial stability, too.

Let’s see how the RBA handles that Gordian Knot.

Bank Fee Income Growing More Slowely

The latest RBA Bulletin includes a section on Bank fees. In 2016, domestic banking fee income from households and businesses grew at a relatively
slow pace of 1.7 per cent, to around $12.7 billion.

Deposit and loan fee income relative to the outstanding value of products on which these fees are levied was slightly lower than in the previous year.

Banks’ fee income from households grew by 1.5 per cent in 2016. This represented a slowing in growth from the previous year, reflecting lower
growth in fee income from housing lending and credit cards.

Growth in fee income from credit cards slowed in 2016 to slightly below the average since 2010, but remains the largest component of fee income from households. The growth in fees was supported by continued take-up of credit cards bundled with home loan packages. There were also more instances of fees being charged, with some banks no longer waiving fees for transferring a credit card balance to a new card provider.

Total fee income from businesses increased by 1.9 per cent in 2016, around the slowest pace for a decade. Slower growth was recorded for fee income from both small and large businesses. By product, growth in fee income
was driven by increases in business loan fees and merchant service fee income from processing card transactions. Fee income from deposit accounts also increased slightly, while fee income from bank bills and other sources declined. The increase in business loan fees mainly
reflected higher reported fee income from small businesses.

Growth in merchant service fee income was mainly attributable to increased transaction volumes, particularly for credit cards due to wider
acceptance of contactless payments. Increased use of platinum and business credit cards, which attract higher interchange fees, also contributed to growth in merchant service fee income from small businesses. Nevertheless, growth in merchant service fee income was evenly spread across small and large businesses.

Total fee take was $12.6 billion, still a substantial sum, but small beer compared with the $31 billion grabbed by the superannuation industry.

Household Debt Rising Further – RBA

The latest chart pack from the RBA to June 2017 includes the worrisome chart on household debt levels.

No sign of a change in trajectory, despite low wage growth and some lending tightening. The last available data point on household debt to income is 188.7 from December 2016.  The March data should be out soon and will be higher again.

Of course this is an average, and some households are in deep debt strife, right now, as higher mortgage rates hit. See our latest mortgage stress analysis released a couple of days ago.

Once Again RBA Holds

The latest from the RBA continues the mixed story, with some better economic indicators, but also higher risks from household debt. As a result they held the cash rate again.

At its meeting today, the Board decided to leave the cash rate unchanged at 1.50 per cent.

The broad-based pick-up in the global economy is continuing. Labour markets have tightened further in many countries and forecasts for global growth have been revised up since last year. Above-trend growth is expected in a number of advanced economies, although uncertainties remain. In China, growth is being supported by increased spending on infrastructure and property construction, with the high level of debt continuing to present a medium-term risk. Commodity prices are generally higher than they were a year ago, providing a boost to Australia’s national income. The prices of iron ore and coal, however, have declined over recent months as expected, unwinding some of the earlier increases.

Headline inflation rates in most countries have moved higher over the past year, partly reflecting the higher commodity prices. Core inflation remains low, as do long-term bond yields. Further increases in US interest rates are expected over the year ahead and there is no longer an expectation of additional monetary easing in other major economies. Financial markets have been functioning effectively.

Domestically, the transition to lower levels of mining investment following the mining investment boom is almost complete. Business conditions have improved and capacity utilisation has increased. Business investment has picked up in those parts of the country not directly affected by the decline in mining investment. Year-ended GDP growth is expected to have slowed in the March quarter, reflecting the quarter-to-quarter variation in the growth figures. Looking forward, economic growth is still expected to increase gradually over the next couple of years to a little above 3 per cent.

Indicators of the labour market remain mixed. Employment growth has been stronger over recent months, although growth in total hours worked remains weak. The various forward-looking indicators point to continued growth in employment over the period ahead. Wage growth remains low and this is likely to continue for a while yet. Inflation is expected to increase gradually as the economy strengthens. Slow growth in real wages is restraining growth in household consumption.

The outlook continues to be supported by the low level of interest rates. The depreciation of the exchange rate since 2013 has also assisted the economy in its transition following the mining investment boom. An appreciating exchange rate would complicate this adjustment.

Conditions in the housing market vary considerably around the country. Prices have been rising briskly in some markets, although there are some signs that these conditions are starting to ease. In other markets, prices are declining. In the eastern capital cities, a considerable additional supply of apartments is scheduled to come on stream over the next couple of years. Rent increases are the slowest for two decades. Growth in housing debt has outpaced the slow growth in household incomes. The recent supervisory measures should help address the risks associated with high and rising levels of indebtedness. Lenders have also announced increases in mortgage rates, particularly those paid by investors and on interest-only loans.

Taking account of the available information, the Board judged that holding the stance of monetary policy unchanged at this meeting would be consistent with sustainable growth in the economy and achieving the inflation target over time.

Total Housing Lending Still Powering On

Today the RBA released their financial aggregates for April.  Total credit grew by 0.4%, or 4.9% over the past year. Housing lending rose 0.5%, or 6.5% over the past year, personal credit fell by 0.1% or 1.5% in the past 12 months, and business lending rose 0.4% or 3.1% over the past year.

There was $1.1 bn of mortgages switched between investment and owner occupation categories in the month.

The 12 month view shows investor lending still accelerating, whilst business lending and other personal credit continues lower.

The more volatile measures shows a fall in housing lending and a rise in business lending.

The aggregates show total housing was $1.66 trillion, up 0.5% of $8.1 billion.  Within that owner occupied loans rose 0.55% of $6 billion and investor loans grew 0.36% or $2.1 billion.

The proportion of lending to productive business fell again, so housing lending is still dominating the scene to the detriment of the broader economy and sustainable long term growth.

The RBA noted:

Following the introduction of an interest rate differential between housing loans to investors and owner-occupiers in mid-2015, a number of borrowers have changed the purpose of their existing loan; the net value of switching of loan purpose from investor to owner-occupier is estimated to have been $52 billion over the period of July 2015 to April 2017, of which $1.1 billion occurred in April 2017. These changes are reflected in the level of owner-occupier and investor credit outstanding. However, growth rates for these series have been adjusted to remove the effect of loan purpose changes.

Credit Suisse says the RBA will need to cut multiple times

From Business Insider.

The Reserve Bank of Australia will need to cut interest rates multiple times as the labour data understates the slack in the economy, according to Credit Suisse.

While jobs growth in April surpassed expectations and the unemployment rate fell to a four month low, full-time jobs fell and the weakness in the detail would have been bigger if not for another month of bias from the sample rotation, Credit Suisse analysts, led by Damien Boey, said in a note to investors.

The Credit Suisse call for cuts is in contrast to the collective market wisdom, which expects the RBA to stay pat at a record low cash rate of 1.5% for the rest of the year.

“The output gap is at levels historically consistent with another cash rate cut,” Credit Suisse said. “We believe there is a case for multiple cuts, because our measure of the output gap is based on upwardly-biased labour market data, and probably understates the degree of slack in the economy.”

That said, Credit Suisse felt the positive headline data means the RBA is yet to get a trigger to change its policy stance.

This chart from Credit Suisse shows the sample bias

Data on Thursday shows Australia added 37,400 jobs, smashing expectations for an increase of 5,000.

However, full-time employment fell by 11,600 over the month, while part-time employment surged by 49,000.

Credit Suisse explains the quality of the data thus:

Employment quality was even more questionable considering statistical distortions. For yet another month, the ABS rotated its sample in favour of cohorts with higher full-time employment to population ratios. There is a notable net upward bias to the full-time employment data since late 2016. In our view, this means that if we were to remove upward statistical biases, the decline in full-time employment in April would have been even greater than officially reported.

Employment leading indicators, based on business and consumer confidence, as well as trend growth in loan approvals point to a near-term bottoming out in the labour market, Credit Suisse said.

However, the official data, thanks to the statistical problem, has stolen the march and shows the jobs market has already bottomed out and when the sample bias reverses, it could start throwing out some ugly numbers.

Credit Suisse is not alone in blaming the data. Commonwealth Bank of Australia economists said the jobs report left them scratching their heads: “Once again the ABS has published an employment report that has left us scratching our heads. Employment is reported to have lifted by a very strong 37,400 in April after increasing by a massive 60,000 in March. To put these numbers in perspective, it’s the equivalent of a 1.2 million increase in US non farm payrolls over two months! To further add to our concerns over the data, total hours worked is reported to have fallen by 0.3% in April and is down by 0.1% over the past two months despite employment having risen by 97,400”.

This chart shows Credit Suisse’s cash rate model

“our cash rate model currently points to one further cut,” Credit Suisse analysts said.

“However, because of our belief that full-time employment gains have been significantly overstated, we think that our output gap proxy understates the amount of slack in the economy. We remain of the view that the RBA needs to cut rates multiple times this year.”

Latest RBA Minutes Warn On Household Balance Sheets

The RBA minutes really tell us little more about the economy, but the did talk about household balance sheets.

“Growth in housing credit had continued to outpace growth in household incomes, which suggested that the risks associated with household balance sheets had been rising” .

See my highlights below.

Domestic Economic Conditions

Members commenced their discussion of domestic economic conditions by noting that inflation outcomes for the March quarter had been in line with forecasts presented in the February Statement on Monetary Policy. As such, the March quarter inflation data had generally increased confidence in the forecast that underlying inflation would pick up to around 2 per cent by early 2018. Both headline and underlying measures of inflation had been ½ per cent in the March quarter. In year-ended terms, headline inflation had been a little above 2 per cent and underlying inflation had increased to around 1¾ per cent. Higher petrol prices and the increase in tobacco excise had both made sizeable contributions to headline inflation; increases in tobacco excise were expected to continue adding to headline inflation over the forecast period. Members noted that the ABS would issue revised expenditure weights for the Consumer Price Index (CPI) in the December quarter 2017 CPI release, which would reflect changes in consumption behaviour over the preceding six years in response to factors including large changes in relative prices.

Prices of tradable items (excluding volatile items) had been little changed in the March quarter but fell over the prior year. Strong competitive pressures in the retail sector had helped keep retail inflation low and there were signs that these pressures were affecting a broader range of consumer goods, such as furniture and household appliances. The appreciation of the exchange rate over the prior year is likely to have weighed on consumer prices.

Non-tradables inflation (excluding tobacco) had stabilised over preceding quarters. There had been signs of stronger price pressures in a few components, including an increase in new dwelling construction costs, which largely reflected a rise in the cost of materials. Utilities prices had also increased strongly in some cities in the March quarter, reflecting the pass-through to consumers of higher wholesale costs for gas and electricity. Members noted that utilities prices in other cities were likely to increase in the next few quarters and that there could be second-round effects on the CPI through upward pressure on business costs.

Working in the other direction, low wage growth and strong competition in the retail sector had contributed to domestic cost pressures remaining subdued. Rent inflation had remained persistently low and was around its lowest level in over 20 years, partly because rents had fallen significantly in Perth. Inflation in a range of administered prices, such as those for education, child care and pharmaceuticals, had been lower than usual, largely reflecting changes in government policy and the benchmarking of some administered prices to the CPI.

GDP growth over 2016 had been around 2½ per cent. Data that had become available over April suggested that the domestic economy had continued to expand at a moderate pace in the March quarter. Members noted that growth in domestic output was still expected to pick up to be a little above 3 per cent by the first half of 2018, as the drag from declining mining investment waned and as resource exports continued to pick up.

The impact of Cyclone Debbie had been most apparent in the spot price of coking coal, which had increased sharply after damage to key infrastructure affected coking coal exports from the Bowen Basin. Coking coal export volumes were expected to be significantly lower in the June quarter before returning to their previous levels over the remainder of 2017 as the damaged infrastructure is restored. Iron ore and liquefied natural gas exports were expected to make significant contributions to growth over the forecast period. Iron ore prices had fallen over the prior month, as had been expected for some time, and oil prices had been lower.

Although Australia’s terms of trade were expected to be higher in the near term than had been forecast at the time of the February Statement, much of the increase in the terms of trade since mid 2016 was expected to unwind over the next few years. As such, the recent rise in the terms of trade was not expected to result in materially more mining investment. However, members noted that the recent boost to mining profits could have other spillover effects, such as higher dividend payments, wage outcomes or government revenues, which represented an upside risk to the forecasts.

Recent data on retail sales growth and households’ perceptions of their personal finances suggested that consumption growth had moderated somewhat in early 2017. Further out, consumption was still forecast to expand at a bit above its average rate of recent years, consistent with the forecasts made at the time of the February Statement. Members noted that if the upside risks to household income growth from the higher terms of trade were realised, consumption growth could be stronger. On the other hand, if households were becoming more focused on paying down debt, this would imply some downside risks to the outlook for household consumption growth. A fall in housing prices could also weigh on consumption growth.

The large amount of residential construction still in progress was expected to support dwelling investment in the near term. Building approvals had been lower over prior months, particularly for higher-density dwellings, suggesting that this pipeline of construction work would continue to be worked off in coming quarters. Members noted that changes in the rate of home-building lag changes in population growth and that this had affected housing prices in some markets in the preceding few years. Growth in housing prices had remained brisk in Sydney and Melbourne, where population growth had been relatively strong, but had been weak in Perth, where population growth had fallen significantly following the end of the mining investment boom. At the same time, there had been some indications that the large increase in supply in the inner-city Melbourne and Brisbane apartment markets had weighed on prices, particularly in the case of Brisbane.

Members noted that surveys of business conditions had continued to improve and that some survey measures of investment intentions had picked up. However, other measures of investment intentions, including those recorded in the ABS capital expenditure survey, suggested that it could be some time before a stronger and more broadly based pick-up in non-mining business investment growth occurs. Other recent indicators of non-mining business investment, including non-residential building approvals and the pipeline of non-residential construction work, were still quite soft. The pipeline of outstanding public infrastructure work, however, had increased further.

Members observed that the unemployment rate had edged slightly higher in recent months to 5.9 per cent, but was expected to decline gradually over the forecast period. Members noted that this suggested spare capacity would remain in the labour market, although there was significant uncertainty about how to measure the degree of spare capacity, particularly given the higher levels of underemployment in recent years. An increase in labour demand could, in the first instance, be met partly by increasing hours worked by part-time employees, which would reduce measures of underemployment but represent an upside risk to the unemployment rate forecasts. The participation rate was slightly higher than had been forecast three months earlier and was assumed to remain around current levels throughout the forecast period.

Employment growth over the March quarter had increased and full-time employment had continued to rise. Members noted that this was in contrast to 2016, when all of the growth had been in part-time employment. Forward-looking indicators of labour demand, including data on vacancies and surveyed employment intentions, indicated that employment growth would pick up a little. Wage growth was expected to increase gradually as labour market conditions improved and the adjustment to the lower mining investment and terms of trade drew to an end.

Members had an in-depth discussion about changes in the composition of employment in recent decades. They discussed the implications of the secular upward trend in the share of part-time employment for labour market spare capacity. The share of part-time employment in Australia, which had increased from around 10 per cent in the early 1970s to over one-third at present, was relatively high by international standards, especially for younger workers; one driver is that students in Australia are more likely to combine their studies with part-time jobs. Data from the Household, Income and Labour Dynamics in Australia Survey suggested that the majority of part-time workers worked part-time as a matter of choice given their personal circumstances, which vary across their lifecycle. People aged between 15 and 24 years are more likely to work part-time at the same time as studying, while a significant share of women between the ages of 25 and 44 years cite child-caring responsibilities as their main reason for working part-time. Furthermore, some older workers indicate a preference for working part-time, possibly as part of their transition to retirement. The survey also indicated that some part-time workers cite a lack of full-time opportunities or that their work requires part-time hours as the main reason for working part-time.

Members observed that growth in part-time employment had become more cyclical over time because businesses had been more able to respond to changes in demand by adjusting the hours worked by employees rather than the number of employees. This increase in labour market flexibility had been enabled by a range of factors including labour market deregulation, technological change and the shift towards a more service-based economy. As a result, the distinction between full-time and part-time work had become less important in assessing labour market conditions. In addition, understanding the degree of spare capacity in the economy required an assessment of the additional hours part-time workers were willing and able to contribute as well as the number of unemployed people.

International Economic Conditions

Members noted that GDP growth in Australia’s major trading partners had picked up since mid 2016 and most forecasters had revised up their outlook for global growth. Recent data had generally confirmed this improved outlook. The stronger activity had been evident in a pick-up in various indicators, including industrial production and measures of business and consumer sentiment, as well as in a broad-based rise in global trade. For some countries, including the United States, Japan and Korea, this had been reflected in an increase in the growth of business investment.

Economic growth in China had retained momentum in early 2017. Property construction and government spending on infrastructure had been among the important drivers of growth and had supported Chinese demand for Australian iron ore and coal as inputs into steel production. The share of investment in nominal GDP had fallen in recent years, while the share of consumption had been rising. Members observed that as economies matured, the share of services in consumption generally increased, which was consistent with the rising share of services in Chinese economic output. Risks around rapid housing price growth had remained a source of concern for the authorities and some ratcheting up of tightening measures had been needed to contain housing price inflation and speculative activity. Members noted that the outlook for the Chinese economy, particularly the residential property market, was an ongoing source of uncertainty for Australian exports and the terms of trade. Another source of uncertainty was how the Chinese authorities might balance achieving their growth targets with the risks associated with high and rising leverage in the Chinese economy.

In the United States, consumption growth had slowed in the March quarter, although this was likely to have been temporary. At the same time, there had been an increase in business investment growth, some of which was related to the energy sector. Survey measures had suggested that the prospects for further growth in business investment were favourable. The unemployment rate had fallen to a level consistent with full employment, while GDP growth was still expected to be above potential over the next couple of years.

Members noted that growth in the euro area was expected to continue at around its recent pace in early 2017. Business credit had increased since late 2016, having declined for a number of years, and the unemployment rate had fallen to its lowest level in nearly eight years. Members noted that the unemployment rate was particularly low in Germany, but had been persistently high in some other countries in the euro area, including France. The Japanese labour market had tightened further and economic growth had exceeded estimates of potential growth in Japan over recent years. Wage growth in Japan had increased a little, but core inflation had remained close to zero and inflation expectations were low.

Core inflation in the major advanced economies had generally remained low. Headline inflation had risen in recent quarters, but was likely to fall back because the effect of the earlier increase in oil prices had started to dissipate. Core inflation was expected to rise gradually in the major advanced economies as spare capacity in labour markets declined further.

Financial Markets

Members noted that financial markets had been relatively stable over recent months and global financial conditions generally remained very favourable. Heightened geopolitical tensions and various political developments had had little effect on financial markets.

Members noted that the widening of the yield spread between French government bonds and German Bunds ahead of the French presidential election had partly unwound following the result of the first round of voting. Members observed that long-term sovereign bond yields in the major markets had remained higher than in the preceding year, but were still low in a historical context.

The Bank of Japan left monetary policy unchanged at its April meeting, but stated that more quantitative easing would be undertaken if needed to reach the inflation target. The European Central Bank also left policy unchanged at its April meeting. Market participants did not expect the US Federal Open Market Committee (FOMC) to change monetary policy at its May meeting. Market expectations were for three increases in the federal funds rate by the end of 2018, compared with five increases implied by the median projections of FOMC members.

Chinese financial market conditions had tightened following the announcement of regulatory measures aimed at reducing leverage in financial markets. Short-term money market rates had risen and corporate bond financing had declined since the end of 2016.

Share prices in major markets had risen over the prior month and equity market valuations remained at high levels. Corporate bond yields generally remained very low, with spreads to government bonds having narrowed over the prior year. Corporate bond yields had mostly moved in line with sovereign bond yields over the prior month, except in China, where yields had increased following announcements by the authorities aimed at addressing high and rising leverage.

Members noted that the cost of borrowing US dollars in short-term foreign exchange swap and bank funding markets had declined from the high levels of 2016, reflecting both demand and supply factors.

There had been relatively little change in major exchange rates over the prior month. The Australian dollar had been little changed against the US dollar and on a trade-weighted basis over the prior month, but had depreciated slightly over the previous few months, which was consistent with the decline in commodity prices.

Australian government and corporate bond yields had generally moved in line with global bond markets over preceding months. Corporate bond issuance had remained relatively subdued, with resource-related corporations using their higher cash flows to reduce debt.

Australian share prices had increased a little over the prior month, with the exception of resource stocks, which had fallen in response to lower iron ore prices.

Members observed that housing credit growth had steadied in early 2017. Growth in investor housing credit had been rising for a time, but had stabilised in preceding months, consistent with the decline in loan approvals to investors. Household credit overall had grown at an annualised rate of 6 per cent over the six months to March. Variable housing interest rates had increased since late 2016, particularly for investors and interest-only lending. As a result, the average estimated interest rate on major banks’ outstanding housing lending had increased slightly, while the average cost of funding was estimated to have been little changed.

Financial market pricing indicated that market participants expected the cash rate to remain unchanged at the May meeting and over the remainder of the year.

Considerations for Monetary Policy

In considering the stance of monetary policy, members noted that the outlook for the global economy remained positive. The broad-based nature of the data supporting this outlook provided some confidence that the expansion could become self-reinforcing. At the same time, the improved conditions and ongoing accommodative stance of monetary policy globally had not, to date, led to a sustained increase in inflation. Members noted that various policy, financial and geopolitical risks to the ongoing expansion in the global economy were still present. The improvement in global economic conditions had helped to support commodity prices, although recent commodity price movements had also been affected by commodity-specific supply factors, such as disruptions to Australian coking coal exports following Cyclone Debbie.

Domestically, inflation outcomes had been as expected in the March quarter. The central forecast for headline inflation was that it would be above 2 per cent over the forecast period; underlying inflation was expected to increase gradually from its current rate of 1¾ per cent. Subdued growth in labour costs and strong competition in the retail sector had continued to have a dampening effect on aggregate inflation. Working in the other direction, rises in utilities prices and the cost of new dwelling construction had increased inflationary pressures.

Members noted that, although it seemed unlikely that wage growth would slow much further, wage pressures were expected to rise only gradually as the effects of structural adjustment following the mining investment and terms of trade boom, which had weighed on aggregate wage growth, continued to wane. Data on the labour market had been somewhat mixed, but forward-looking indicators continued to suggest that employment growth would maintain its recent pace and spare capacity in the labour market would decline gradually.

Recent data suggested that the Australian economy had grown at a moderate pace at the beginning of 2017. The outlook was little changed from three months earlier and continued to be supported by the increase in the terms of trade and the low level of interest rates, although lenders had announced increases in mortgage rates, particularly those paid by investors and on interest-only loans. The pick-up in non-mining business investment had been modest and forward-looking indicators of investment remained mixed. The drag from the fall in mining investment (and the spillover effects of this on non-mining investment and activity) had continued to ease. Recent data had provided further signs that the downswings in the Western Australian and Queensland economies were coming to an end. The depreciation of the exchange rate since 2013 had assisted the economy through this transition; an appreciation of the exchange rate would complicate this adjustment process.

Conditions in the housing market continued to vary considerably across the country. Conditions in established housing markets in Sydney and Melbourne remained robust, but housing prices had been falling in Perth. The additional supply of apartments scheduled to be completed over the next couple of years in the eastern capital cities was expected to put some downward pressure on growth in apartment prices and on rents, particularly in Brisbane.

Growth in housing credit had continued to outpace growth in household incomes, which suggested that the risks associated with household balance sheets had been rising. Recently announced supervisory measures were designed to help mitigate these risks by reinforcing prudent lending standards and ensuring that loan serviceability was appropriate for current financial and housing market conditions. However, it would take some time to assess the full effects of recent increases in mortgage rates and the additional supervisory focus.

The Board continued to judge that developments in the labour and housing markets warranted careful monitoring. Taking into account all the available information and the updated forecasts, the Board’s assessment was that maintaining the current accommodative stance of monetary policy would be consistent with achieving sustainable growth and the inflation target over time.

The Decision

The Board decided to leave the cash rate unchanged at 1.5 per cent.

Housing Finances Under The Microscope

The latest RBA Quarterly Statement on Monetary Policy says low wages growth will cramp growth, and also includes information on household finances and mortgage lending.  They say that interest only investors have seen an average rise of 35 basis points since Nov 2016, and a principal and interest investor of 28 basis points. Personal loan rates have also risen by 25 basis points since April 2016 (despite cash rate cuts). Major banks have a lower share of the home loan market as more business to the non-banks and other lenders.

Housing credit growth was stable in recent months at an annualised rate of around 6½ per cent. Growth in credit extended to investors has steadied at an annualised pace of around 8 per cent, after accelerating through the second half of 2016. This stabilisation in investor credit growth is consistent with the slight reduction in investor loan approvals and may have been partly driven by the increases in interest rates for investors in late 2016 along with further tightening in lending standards by lenders around that time.

The decline in loan approvals in recent months has been driven by a decline in approvals in Victoria, while loan approvals in New South Wales have remained near record highs (Graph 4.11).

Housing finance for new dwellings has been little changed recently following rapid growth through 2016; housing finance for the construction of new homes has remained stable (Graph 4.12). Overall, loans for new dwellings or dwellings under construction are estimated to have contributed more than half of credit growth over the past year. This contribution is expected to rise, based on the pipeline of residential construction work under way.

The major banks’ share of housing loan approvals has fallen in recent months to its lowest level since 2008. Most of this reduction appears to have been absorbed by other Australian and foreign banks (Graph 4.13). Housing credit issued by entities that are not licensed by APRA as authorised deposit-taking institutions (ADIs) is estimated to have increased slightly in recent quarters, but at around 3 per cent remains a very small share of housing credit.

The further increases in housing interest rates announced by some lenders in March and April and prudential guidance from APRA and ASIC regarding interest-only lending can be expected to affect housing credit growth over the months ahead.

As outlined in the April Financial Stability Review, the Council of Financial Regulators (CFR) has been monitoring and evaluating the risks to household balance sheets. APRA announced further measures in March 2017 to reinforce sound housing lending practices. ADIs will be expected to limit new interest-only lending to 30 per cent of total new residential mortgage lending and, within that, to tightly manage new interest‑only loans extended at loan-to-value ratios above 80 per cent. APRA also reinforced the importance of banks: managing their lending so as to comfortably meet the existing investor credit growth benchmark of 10 per cent; using appropriate loan serviceability assessments, including the size of net income buffers; and continuing to exercise restraint on lending growth in higher risk segments. APRA also announced that it would monitor the growth in warehouse facilities provided by ADIs. These facilities are used by non-bank mortgage originators for short-term funding of loans until they are securitised.

In addition, the Australian Securities and Investments Commission (ASIC) announced in April further steps to ensure that interest‑only loans are appropriate for borrowers’ circumstances and that remediation can be provided to borrowers who suffer financial distress as a consequence of shortcomings in past lending practices.

Since February, the major banks have announced an average cumulative increase to their standard variable rates of around 25 basis points for investors and a few basis points for owner‑occupiers. Also, borrowers will pay an additional premium for interest-only loans of around 15 basis points for investors and 20 basis points for owner-occupiers (Graph 4.14).

The rates actually paid on new variable rate loans are likely to differ from the major banks’ standard variable rates. The major banks and other lenders offer discounts to their standard variable rates, which can vary through time particularly for new borrowers; for example, in 2015, increases in interest rates on existing borrowers were reportedly accompanied by larger unadvertised discounts for new borrowers.

Overall, the increases that have been announced to date by lenders are expected to raise the average variable rate paid on outstanding housing loans by around 15 basis points. The average outstanding rate on all housing loans is expected to increase by slightly less than the variable rate since interest rates on new fixed-rate loans remain below those on outstanding fixed-rate loans.

As has been the case for some time, there is considerable uncertainty around the timing and extent to which domestic cost pressures will rise over the next few years. As wages are the largest component of business costs, the outlook for wage growth is particularly important for the inflation outlook. The recovery in wage growth could be stronger than anticipated if conditions in the labour market tighten by more than assumed, or if employees demand wage increases to compensate for the sustained period of low real wage growth. However, it could be the case that some of the factors currently weighing on wage growth, such as underemployment in the labour market or structural forces such as technological change, are more persistent or pervasive than assumed.

The path of inflation will also depend on whether the heightened competitive pressures in the retail sector continue to constrain inflation. On the other hand, the earlier increases in global commodity prices and increases in domestic utilities prices could flow through to domestic inflation (through higher business costs) by more than assumed.

Another factor affecting the outlook for CPI inflation is that the weight assigned to each expenditure class in the CPI will be updated in the December quarter 2017 CPI release. Measured CPI inflation is known to be upwardly biased because the weight assigned to each expenditure class is fixed for a number of years.

This means that the CPI does not take into account changes in consumer behaviour in response to relative price changes (known as ‘substitution bias’). As a result, the forthcoming re-weighting is expected to reduce measured inflation, although it is hard to predict by how much because the effects of past re-weightings have varied significantly and are not necessarily a good guide to future episodes. The ABS plans to re-weight the CPI annually in future, which will reduce substitution bias on an ongoing basis.

The crash the RBA fears: it’s not housing and banks, it’s you

From The New Daily.

In a landmark speech, Reserve Bank of Australia governor Philip Lowe has outlined his nightmare scenario of a property market crash, as well as his favourite solution to the affordability crisis.

The RBA is not overly concerned that a “severe correction in property prices” would trigger a banking collapse, as happened in the US in 2008-09, Dr Lowe said on Thursday.

No, he said he was far more worried that Australians would bring the economy to a grinding halt by curbing their spending.

“The Australian banks are resilient and they are soundly capitalised. A significant correction in the property market would, no doubt, affect their profitability. But the stress tests that have been done under APRA’s eye confirm that the banks are resilient to large movements in the price of residential property,” Dr Lowe told the Economic Society of Australia.

house prices household debt“Instead, the issue we have focused on is the possibility of future sharp cuts in household spending because of stretched balance sheets.”

Household debt is “high” relative to incomes, making it likely that many Australians would respond to a market correction with a “sharp correction in their spending”, in an attempt to pay down debt.

“An otherwise manageable downturn could be turned into something more serious.”

The golden solution

Dr Lowe’s speech contained a comprehensive answer to what has caused house prices to skyrocket, at least in Sydney and Melbourne, and what should be done to fix it.

The answer was unlikely to be comforting for either the Liberals or Labor, as it touched on both supply and demand-side fixes.

He dismissed allowing young Australians to use their superannuation for a deposit. “You don’t address affordability by adding to demand.”

But he also downplayed the importance of tax policies. “The best housing policy is really a transport policy,” he said during a question-and-answer session at the end.

In the speech itself, the Governor blamed the house price explosion on an encyclopaedic list of factors, including an increased ability to borrow via financial liberalisation and lower interest rates; supply constrained by zoning issues, geography and, crucially, inadequate roads and trains to link outer suburbs to the inner city.

He also pointed to Australians’ preference for big houses in the big cities; slow income growth; stronger-than-expected population growth; and the rise of investors.

While much has been made of the crackdown of APRA and ASIC on bank lending to investors — indeed, constraining investor demand is the centrepiece of Labor’s solution — Dr Lowe placed far more emphasis on supply issues.

“This borrowing [by investors] is not the underlying cause of the higher housing prices. But the borrowing has added to the upward pressure on prices caused by the underlying supply-demand dynamics. It has acted as a financial amplifier in some cities, adding to the already upward pressure on prices.”

The Governor noted in passing that tax policies (presumably negative gearing and the 50 per cent capital gains tax discount) would “have an effect”, but he was more optimistic about faster rates of home-building, better transport infrastructure, and an eventual rise in the RBA’s cash rate.

“Increased supply and better transport could be expected to help address the ongoing rises in housing prices relative to incomes. These changes and some normalisation of interest rates over time might also reduce the incentive to borrow to invest in an asset whose price is rising strongly.”