Central bank speak can be difficult to decipher most of the time. But an impatient (and frustrated) central bank can make the task of economists that bit easier. For some time now, the Reserve Bank of Australia has been waiting for more tangible evidence of a handover from the resources sector to the non-mining sectors of the economy. While it has continued to wait, it has continued - reluctantly - to cut the official cash rate (OCR), which now stands at 2.75%, even lower than the financial crisis trough.
A seamless transition looks less likely than ever, which Glenn Stevens, the RBA Governor, all but acknowledged in a speech entitled Economic Policy After the Booms. The Governor re-iterated that there is scope for non-mining economy - notably dwelling investment and non-mining capital investment - to emerge as two key drivers of growth. But he admitted that although there is ample scope for both to rise, this was no certainty and that while there are signs of an increase in dwelling investment getting underway, a recovery in non-mining capex looks a long way off.
The RBA has been talking up the cyclical tailwinds supporting dwelling investment, notably low and declining mortgage rates, low rental vacancy rates, strong rental yields and house prices that are well off their 2011-12 troughs in most capital cities. Building approvals are up strongly over the past year and the RBA recently cited the +15% growth in new mortgage lending in the past 12 months as evidence of a pick-up in housing. But the breakdown in new finance commitments advises some caution. Investors and repeat buyers account for all the growth in new lending in the past year; finance commitments to first home buyers have remained flat over this time. The composition of new mortgage lending is important for broader consumption, because the multiplier effects to consumer durables is likely greater for first home buyers. Moreover, the release of the June building approvals data - showing a seasonally adjusted 7% decline confirmed the softer trend of recent months. That approvals for detached dwellings remain close to a cyclical low suggests that the impetus to economic growth is likely to be less than in previous housing recoveries.
The RBA has clearly over-estimated the prospect of a recovery in non-mining capital investment, both in terms of timing and size, reflected in the frank admission that the recovery was a long way off. It wasn't meant to come to this of course; as the resources boom came to an end, a decline in the $A associated with lower commodity prices would facilitate the handover from mining to non-mining capex. The Governor is clearly frustrated the $A hasn't performed its shock absorbing role on cue; according to the RBA, it remains stubbornly high given the decline in the terms of trade.
The weakness in non-mining investment should come as little surprise to those closely following the fortunes of the stock market. The key themes from the past two reporting seasons have been widespread cost cutting and a related lift in dividend payout ratios. Put simply, the market's appetite for income remains insatiable. When even an investment bank - Macquarie - lifts its payout ratio to 80% with a target of maintaining its payout above 60% for the foreseeable future - the market clearly isn't rewarding companies that invest for growth. And the three big sectors of the market - banks, resources and telecommunications - remain inwardly focussed on cost control, designed to offset the prospect of weak revenue growth. Expect leverage to remain low, the corporate savings rate to remain at record highs and the outlook for non-mining business investment to remain weak.
The RBA Governor is clearly frustrated at the low level of confidence, and sees this as a key source of restraint amongst households and businesses. And reading between the lines, he believes that some of the uncertainty and pessimism stems from Canberra. But the Governor does not link negative sentiment to the role that excessively tight monetary policy might have played. Graph 2 in the speech shows that real per capita non-financial assets (mainly housing) have stagnated over the past five years and financial assets remain slightly below their 2007 peak. The actions of the major central banks in recent years has brought into sharper focus the fact that expectations and the wealth effect are crucial in the monetary policy transmission mechanism. We can only hope that at some point, the RBA acknowledges - even just internally - that monetary policy has been too tight for too long and that this has contributed to negative sentiment, and the slow recovery in asset values and non-mining sectors of the economy more broadly.
The RBA remains a reluctant rate cutter and this is unlikely to change. Deteriorating business conditions and benign inflation has forced its hand to some extent, but it remains paranoid about financial stability. Perhaps it believes that the Greenspan Fed kept policy too loose for too long during the 2000s and this this contributed to the credit and housing booms. Thus it remains sensitive to stoking another period of strong asset price inflation which would undermine its ability to maintain financial stability. But with credit growth remaining tepid - it has expanded by 3% in the past year - financial conditions are far from accommodative notwithstanding the low level of the OCR. And inflation and inflation expectations are likely to remain well contained despite the lower $A, reflecting the cost cutting measures cited above that are being adopted across corporate Australia. This has been going on for several years now and efforts at the micro level to lift efficiency are now paying dividends in terms of renewed strength in aggregate productivity growth and outright declines in unit labour costs.
The Woolworths quarterly sales conference call held today provides some insights into future trends in food inflation - which comprises 15-20% of the inflation basket. Woolworths noted that the 'more savings everyday' campaign is working well with the next phase being introduced in coming weeks. Moreover, Woolworths' ongoing aggressive roll-out of Masters stores will likely see renewed price competition with Bunnings in the hardware, building and garden supplies categories.
Beyond the prospect of a rate cut in August, I believe that continued weakness in non-mining capital investment, a modest and uneven recovery in dwelling investment (by historical standards) and benign inflation will continue to force the hand of the reluctant rate cutter. I put the probability of an OCR starting with a 1 by March next year at 75%.
For those interested in stock market implications, domestic cyclicals have delivered strong performance this year against the backdrop of monetary easing. A basket of seven discretionary retail and building material stocks has delivered an accumulated return of over 25% year to date, well above the ASX200 accumulated return of 10%. Skeptikoi expects these stocks to continue to be re-rated if the RBA continues to lower the OCR as per above.
It is unfortunate that the RBA remains risk averse at a time that risk appetite has deserted the household and corporate sectors. Surely, the task of a central bank is to be countercyclical; take away the punch bowl as the party is heating up, but conversely, put the punch bowl back and even spike it when the party looks to be coming to a premature end. If the RBA considers that it has had to steer policy though a difficult course over the past year, the next six months promise to further test the resolve and patience of the reluctant rate cutter.
