RBA seems under less pressure to cut rates amid rebound in domestic demand, says Capital Economics

The Reserve Bank of Australia (RBA) may yet cut rates to 0.25% in response to the drag on economic activity from the bushfires and the coronavirus. But with domestic demand rebounding as the housing slump has turned to boom, the urgency to support the economy has diminished, according to the latest research report from Capital Economics.

The RBA kept rates unchanged at 0.75 percent last week and Governor Lowe noted in comments to the House of Representatives on Friday that the Bank had been discussing “the case for a further easing of monetary policy”.

However, even if the economy does shrink this quarter, it should recover some of that lost ground in Q2. And the bigger picture is that the urgency to lower interest rates has declined recently. First, the housing market is now firing on all cylinders.

House prices across the eight capital cities rose at an annualised pace of nearly 20% in the three months to January and leading indicators point to continued strong growth over the next few months.

By making construction of new homes more attractive, rising home prices have contributed to the rebound in building approvals from their July trough. While the current level of approvals still points to falling dwellings investment, we think it will bottom out by mid-year.

By lifting household wealth, rising home prices are also providing support to consumption. Indeed, retail sales volumes rose the most since Q2 2018 in the fourth quarter. Some of that pick-up may reflect the government’s $8bn tax refunds but with 60% of those refunds already paid by the end of September and we still expect consumption growth to remain soft at 0.3% q/q in Q4. But it’s worth noting that the RBA didn’t respond with additional easing to the measly 0.1% q/q increase in consumption in Q3, the report added.

Governor Lowe noted last week that low interest rates could affect resource allocation and confidence. And he noted that cutting interest rates any further could encourage more borrowing “at a time when housing debt is already quite high and there is already a strong upswing in housing prices in place”. That’s more hawkish than his comments from October when he noted that rising house prices would only become a problem if “if housing credit growth were to pick up a lot”.

Mr Lowe argued that the Bank would brush those concerns aside if the labour market turned for the worse. That’s looking increasingly unlikely as job vacancies are showing signs of bottoming out and the unemployment rate fell from 5.3% in October to 5.1% in December. With spare capacity in the labour market not rising any further, wage growth may hold up and underlying inflation may not fall any further below the lower end of the RBA’s 2-3% target range.

"All told, we are sticking to our forecast that the RBA will cut rates to 0.25% over the coming months. But if demand proves more resilient to the outbreak of the coronavirus than we are anticipating and if the unemployment rate remains broadly stable, the RBA’s easing cycle may already have come to an end," Capital Economics further noted in the report.