A gift to the next government

This month the Federal government celebrated its 11th anniversary in office. The opinion polls indicate this could be its last. Prime Minister John Howard seeks to regain ground by claiming the economy does not “run on autopilot” and needs the stewardship on the coalition can provide. Yet in the early years of his government monetary policy, at least, was running on autopilot.

Interest rate cuts that occurred in the early years of his government were already locked-in at the time of the March 1996 election. They would have happened irrespective of which party won. All the Reserve Bank had to do that year was to decide when to turn on the autopilot. The interest rate cuts that began a few months after the 1996 election were ready to go on autopilot well before the election; the new government inherited them.

In fact, a new government later this year would be in a similar position to the coalition in 1996. It stands to inherit a very advantageous monetary policy, just as the coalition did. The next few years could be one in which sustained cuts in interest rates could occur; they would be locked in as though on autopilot.

That, in turn, would set off a whole new cycle, possibly leading to a boom around the start of the next decade.

Let me explain how I think a new government (or the incumbent should they retain office) could inherit a period marked by interest rate cuts as the coalition did in 1996. The yield curve sets up the autopilot for rate changes as it is the best guide to the future direction of monetary policy. (Click here.)

A steepening in the yield curve tends to be a signal that monetary policy might be getting more accommodative (too stimulatory), requiring cash rates to rise. A flattening in the yield curve tends to signal that monetary policy might be getting more restrictive. That could lead to an economic slowdown unless the central bank begins to cut short-term (cash) rates.

Now back to the times when there was last a change of government:

• The yield curve began to steepen rapidly from January 1994.
• Cash rates rose between August and December 1994.
• Rates rose 275 basis points and stayed at 7.5% until after the 1996 election.
• But the yield curve had peaked in July 1994 and kept flattening at a rapid pace thereafter.
• That suggested cash rates could have begun to be cut. The autopilot was set for rate cuts.

A prudent central bank may wait six months or so to make sure the yield curve flattening was sustained. By early 1995 interest rates could have been cut and the autopilot could have been switched on for more cuts. Certainly after a year’s lag, rates should have been cut by mid-1995. Yet no rate changes occurred likely because the Reserve Bank, then under governor Bernie Fraser, delayed switching on the autopilot to ensure inflation was well and truly vanquished. In that he was most successful and, as it turned out, the most non-partisan of modern Australian central bank governors.

Then:

• March 1996 Labor was defeated after 13 years in office.
• July 1996, cash rates began to be cut. The autopilot was turned on.
• Cuts reversed all 275 points over the next 8 months to December 1998.

So back to the present: Cash rates are now some 60 points higher than 10-year bond yields (and bank bill futures near 75 points higher than 10-year bonds), the yield curve is inverted and has been flattening for some time. This would tend to imply that not only are more rate hikes almost surely out of the question but that a new (or further-tenured government) is likely to inherit a monetary policy that could sustain several rate cuts over the last years of this decade. That should pave the way for a return to more buoyant activity levels. All that has to be done is to turn on the autopilot and enjoy the rate cut euphoria.

Dr Ron Woods is chief economist and market strategist at http://www.econoclast.com.au, a new subscription-only service that delivers regular commentaries and analysis of the economic landscape.