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We need more rate cuts

David Bassanese
Wednesday, June 03, 2015

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By David Bassanese

The Reserve Bank of Australia’s latest decision not to reinstate an “explicit” easing bias in yesterday’s policy statement has had the predicted effect – pushing up the Australian dollar to still quite uncomfortable levels.

To my mind the Reserve Bank’s decision is yet another missed opportunity, and risks undermining business and consumer confidence just at a time when the Abbott Government is desperately trying to boost animal spirits through its more generous May budget.

Why did the RBA remain tight lipped? There are probably a few reasons, none of which, however, I find all that convincing.

The Budget boost

For starters, the RBA likely noted the May Federal Budget has been warmly received – at least compared to the debacle of last year – and has already had a notable effect in pushing up consumer confidence. We’re yet to see clearly the reaction of business, most notably through the National Australia Bank monthly business survey. But chances are business confidence will likely spike higher also.

The $5 billion small business package might also create a spike in retail spending over May and June as accelerated depreciation allowances encourage the purchase of small capital items – such as computers, printers and cars – to claim the immediate tax deduction.

News from the United States also suggests the Federal Reserve will not waver from raising interest rates by September – despite the recent signs of slowing in the economy. In an important speech just over a week ago, Fed chairperson Janet Yellen dismissed recent signs of economic weakness, suggesting they may be only temporary and reflective of poor winter weather, a bout of industrial disputation and seasonal adjustment quirks in the data.

The RBA is no doubt hoping that higher US interest rates will eventually pull down the Australian dollar – without local interest rates needing to be cut much further, if at all.

Upbeat consumers

The RBA has also likely been encouraged by recent signs of stronger consumer spending – at least as measured by retail sales – together with a slight pick up in the pace of employment growth. As the RBA noted in its statement yesterday “household spending has improved, including a large rise in dwelling construction, and exports are rising.”

In trend terms, the unemployment rate has tended to level out at just over 6% since late last year. And the ANZ measure of job advertisements continues to trend higher – which ordinarily would suggest a sub-6% unemployment rate. The still high unemployment rate suggests while job hiring is lifting, this is being offset by still heavy job losses elsewhere in the economy, most likely due to the mining bust.

That said, the biggest economic shock over the past month was the depressingly bad March quarter capital expenditure survey – which pointed to both a decline in business investment during the previous quarter, and a large downgrade to investment expectations over the coming year. The latest survey suggests business investment could slump by 20% next financial year, comprising a 30% decline in mining investment and a 10% decline in non-mining investment. Of course, this survey predates the latest interest rate cut and the more upbeat May Federal Budget. And it’s also true this survey only partly captures total business investment (notably excluding the booming health sector), and expectations could easily be revised higher in future surveys.

However, anywhere near a 20% decline in business investment next year would be an ominous sign, as it’s the type of decline usually only seen in recessions – such as in the early 1980s and early 1990s. After all, business investment accounts for around 15% of GDP, so a 20% decline would detract 3 percentage points from economic growth. It would take major increases in spending elsewhere in the economy to prevent growth slipping into negative territory.

The hand of housing

Against all this, the other major factor likely staying the RBA’s hand was the ongoing strength in Sydney property prices – with Federal Treasury Secretary John Fraser now suggesting the city is now unequivocally in a “bubble”. By my estimates, as seen in the chart below, it is true that median Sydney house prices to average disposable household income have now surpassed the peaks of the 2003-04 boom – so in that sense we arguable are moving into bubble territory.

But due to very low interest rates, Sydney home loan (un)affordability (for those that can meet deposit requirements) is only a little above its longer-run average – and well below the peaks of 2003-04. This highlights the dilemma for the RBA – the lower rates go, the great scope there is for house prices in Sydney to potentially rise even further, which adds to the risk of a harder landing later when interest rates inevitably re-normalise.

Indeed, it’s not true to say Sydney house prices are unlikely to fall in nominal terms. Based on the Australian Bureau of Statistics house price estimates, Sydney prices had a peak to trough decline of 9.6% between December 2003 and March 2006, and a decline of 3.7% between June 2010 and December 2011. I doubt this time will be much different and would expect at least a 10% correction in nominal Sydney house prices during the next downswing of the cycle. That, however, is unlikely to be a crash – and such a crash remains unlikely unless we get an unexpected surge in inflation and/or a very deep recession.

It is the growing non-negligible risk of recession in 2015-16 that suggests to me the RBA should have still erred on the side of retaining a bias to ease interest rates in yesterday’s statement. As for Sydney house prices, Treasury Secretary John Fraser is probably correct in trying to jawbone some of the froth out the market, and both the Federal Government and the RBA would be wise to follow his lead.

To the extent the Sydney property boom can be tempered through either jawboning or macro-prudential controls, it will free up scope for the RBA to support the rest of the economy – and help drive down the $A - by cutting interest rates further.

Published: Wednesday, June 03, 2015

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