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Goldman Sachs says El Nino could force RBA to cut interest rates

A severe drought from an intense El Nino weather pattern may drag Australia’s growth below 2 per cent and force the Reserve Bank of Australia to cut interest rates, Goldman Sachs says.

Australian policy makers are anticipating flat farm production in 2015-16, but have not factored in a drought. The Bureau of Meteorology has forecast a “significant shift” towards a drier and hotter December quarter as the El Nino pattern reaches its peak.

Goldman Sachs, led by head of macro research in Australia Tim Toohey, said in a drought year, farm production declined by a median 20 per cent.

“Somewhat fortuitously, in Australia the 1994-95, 2002-03 and 2006-07 droughts all happened to coincide with very robust economic growth,” it said in a note this week.

In those periods, Australian gross domestic product tracked at more than 4 per cent.

But the prospect of falling farm incomes against a backdrop of the challenges of lower commodity prices and record low wage growth was threatening the modest recovery in Australia’s non-mining economy, which had partially offset the end of the resources boom.

The onset of El Nino has Australia’s grain farmers bracing for the worst, with Rabobank saying wheat production was 27 per cent lower in El Nino years.

“The emergence of early warning indicators of a severe drought event in Australia and New Zealand comes at an uncomfortable time for policy makers in both countries,” the Goldman Sachs note said.

Mr Toohey said the investment bank was concerned its GDP growth forecast for 2016 of 2 per cent understated the risk of an intensifying drought in agricultural parts of Australia.

That should provide “sufficient reason” for the RBA to cut interest rates, they said.

“We continue to expect the RBA to ease interest rates by 25bps in November and then to reduce interest rates by 25bps in December.”

“If there is to be additional monetary easing in both countries in 2016, the depth and severity of any drought will not be an insignificant factor.”

The note comes as London-based macroeconomic forecasting agency Lombard Street Research said record low interest rates were proving less effective in boosting Australia’s economy than the depreciation of the Australian dollar, while risks to economic growth tilted to the downside.

“The non-mining sector has turned around, with manufacturing and service exports growing at their fastest pace since the crisis – a development that has attracted relatively little attention,” Lombard Street Research economist Konstantinos Venetis said.

But the fall in the Australian dollar, currently trading around US73¢ with analysts anticipating a fall below US70¢ by year’s end, was having a stronger and quicker effect on real activity than lower interest rates.

“Investment has been relatively unresponsive to successive policy rate reductions, and it should continue to be so for a while longer,” Mr Venetis said.

The road would become more difficult for the RBA, with the mining boom expected to totally unwind by the end of 2016 and external drivers including China’s slowdown skewing risks for GDP growth to the downside.

“Supported by a weaker currency, Australia’s non-mining sector has been taking up some of the slack left by the receding resource boom,” Mr Venetis said.

“But there is a good chance that the low-hanging fruit has been picked, skewing the near-term risks for GDP growth to the downside and complicating policymakers’ reaction function.”

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