All roads lead towards cash rate neutrality

Chances the Reserve Bank will cut interest rates any further are becoming extremely slim as key local and global economic indicators pick up.

The reasons why the Reserve Bank may contemplate further interest rate cuts are almost as scarce as hen’s teeth.

Job advertisements are rising suggesting the unemployment rate may top out around 5.5 per cent for this cycle. House prices are on a rip, rising nearly 3 per cent in the last three months with the momentum pointing to strong double digit gains ahead. GDP growth continues to run along at a trend 3 per cent pace, plus or minus a quarter of a per cent of so. If anything, GDP growth is poised to pick up. At the same time, consumer sentiment has leapt higher in recent months with this new found optimism spilling over to a nice lift in retail spending in the early part of 2013.

Consumers are also wealthier. In addition to the gains in house prices, the Australian stock market has added over $300 billion in value from the lows in the middle of 2012. This will no doubt underpin a lift in consumer spending in the months ahead. New housing sales have already risen by around 17 per cent in the last four months.

Now throw in improving business confidence, a gradual lift in construction activity and buoyant business investment plans and the check-list on the Australian economy is particularly favourable.

At the same time, there is a strong run of steadily improving news from the global economy. The US is locking in a run of decent growth while China remains strong. Even the eurozone and India are starting to beat expectations, albeit from a low starting point.

Why would the Reserve Bank cut interest rates in these circumstance when monetary policy is already stimulatory?

About the only reason to consider a further interest rate cuts is the strong Australian dollar and even that is not so compelling given the recent depreciation.

It is also important to acknowledge that one of the high-profile reasons for the 2011 and 2012 interest rate cuts was financial market instability and the cost of credit. Tight market conditions and increased funding costs necessitated easier policy so that mortgage and business interest rates were not increased. Over recent months, financial market conditions have normalised for banks, which is lowering their cost of funds so this just might give the scope for the banks to deliver an out of cycle rate cut.

In simple terms, the economy is in the early stages of what looks to be a strong upswing from the 2012 mid-cycle slowdown with there also being a clear improvement in market conditions.

This means that not only does it look like interest rates are on hold for a while with the next move likely to be up, but the upcoming budget may well show more favourable conditions.

Treasury is currently starting the work of preparing the economic forecasts that will underpin the 2013-14 federal budget to be handed down by Treasurer Wayne Swan on May 14.

While the forecasts will be refined and subject to some changes over the next seven or eight weeks as more economic and financial market news comes to hand, Treasury is likely to be preparing forecasts that suggest the economy is to pick up strongly through 2013 and into 2014. This means that GDP growth is poised to lift to a 3.5 to 4 per cent pace in 2013-14, which would mean the unemployment rate will start to fall within the next year. While Treasury is unlikely to say it, there is a better than even chance the unemployment rate will be below 5 per cent this time next year.

In terms of the world economic backdrop, global GDP growth is looking to return to trend or higher on the back of super-stimulatory monetary policy settings. The two largest economies in the world, China and the US, are on track to grow solidly. Conditions in the eurozone are consolidating, even though Italy is presenting a threat to the medium-term outlook.

Australia looks to be entering a sweet spot – strong and sustained economic growth, low unemployment and with it low inflation.

This mix means the Reserve Bank may want to think about moving interest rates to neutral and it should help whoever wins the September 2013 election lock in some budget surpluses over the next few years.

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