Australia's bipolar rates wrestle

Is the next move in interest rates up or down?

Of course, nobody knows for certain. But instead of listening to the squabbling of market economists, it's much better to try and work out how the Reserve Bank itself is approaching the question. After all, it's the one that's going to make the decision.

Fortunately, the Reserve's deputy governor, Philip Lowe, recently gave a speech that provided us with an extremely valuable insight into how our central bank sees the major forces at work in our economy.

According to Lowe, the Australian economy is currently in the grip of two very powerful forces. First of all, there's once-in-a-century surge in investment that's taking place as mining companies position themselves to take advantage of the resources boom.

As Lowe pointed out, over the past year, business investment has soared by around 20 per cent. And there's a lot more to come. In fact, based on the plans that the miners have already announced, the Reserve Bank is expecting double-digit increases in investment over the next couple of years.

If this happens, investment's share of GDP is set to rise to a record peak of more than 18 per cent, well above the levels we've seen in the past.

As Lowe noted, the increasing industrialisation and urbanisation of Asia is not only responsible for boosting commodity prices, it's also pushing the prices of manufactured goods lower. As a result, Australia's terms of trade (the prices we receive for our exports relative to the prices we pay for imports) are very high. This means the benefits of the commodity boom are spread through the economy, because consumers and businesses outside the resource sector also benefit from lower import prices.

Even more importantly, Lowe pointed out that Australia's high terms of trade has caused the Australian dollar to soar. As a result, the prices we now pay for many manufactured goods are, on average, no higher than what they were a decade ago, even though average household incomes have climbed by more than 60 per cent over that period. Because the prices of so many goods have remained steady while incomes have climbed, people living in towns and cities far away from the big mining centres now have a lot more money in their pockets to spend on services.

As he pointed out, a number of industries are benefitting from the spill-over effects from the mining boom. "Day to day, they can be hard to see but they do percolate through the economy. In effect, there is a chain that links the investment boom in the Pilbara and in Queensland to the increase in spending at cafs and restaurants in Melbourne and Sydney.”

The trouble is that this massive investment boom has come at a time when the Australian economy is already enjoying solid growth, and unemployment is low. So you'd expect that the extra spending on investment would result in excessive demand, which would fuel inflationary pressures, and cause the Reserve Bank to lift interest rates to cool the economy.

But Lowe noted that there's a strong countervailing force at work. The rise in Australia's terms of trade has made our dollar a lot stronger, and this has undercut the international competitiveness of many of our industries. And this is exerting a strong contractionary pressure on some parts of the economy.

Not surprisingly, the industries that are doing it toughest as a result of the strong dollar are manufacturing, tourism and education, as well as parts of the agricultural sector, and in some business services sectors. Companies in those sectors are increasingly realising that the strong dollar is here to stay, and are adjusting their strategic plans. Some have decided to undertake new investment to boost their competitiveness, but others have decided to scale back production, or even to close down operations altogether.

Now, it's historically very unusual to have an investment boom and a very high exchange rate (adjusted for inflation, Australia's exchange rate is at its highest level since the early 1970s). As a result, it's hard to know whether the expansionary pressure from the investment boom and surging terms of trade will ultimately prove stronger than the contractionary force generated by the strong Australian dollar, or whether the opposite will be the case.

Lowe noted that over the past year, the two opposing forces have tended to balance each other out, and as a result, the economy grew around trend, inflation remained within the bank's target range and employment was strong.

But he pointed out that when it came to industry, things are a lot more complicated. The Australian economy is undergoing a huge structural shift, with some industries – such as mining – growing in relative importance, while others are contracting. As a result, it's hard to be sure how the powerful but opposing forces will balance out.

But you can be sure that the Reserve Bank is watching the outcome extremely closely. If the expansionary forces get the upper hand, the economy will likely overheat, which will likely fuel inflationary pressures and cause the Reserve Bank to push interest rates higher to dampen economic activity.

On the other hand, if the contractionary forces prove dominant, economic activity will falter, inflationary pressures will weaken and the Reserve Bank will be quick to cut interest rates.