Calm down, this is no rates emergency

Those worried about a cash rate below GFC settings are missing a few key points. Fiscal policy and the Australian dollar are no longer the stimulatory factors they were then.

Anyone who reckons interest rates are at emergency levels has a poor understanding of economics, economic policy and economic history.

To be sure, the Reserve Bank interest rate cut yesterday has the official cash rate at 2.75 per cent which is, of course, below the 3 per cent low point that prevailed during the depths of the global banking and economic crisis.  But the other policy levers are so vastly different that all talk of ‘emergency monetary policy’ is economic clap trap. 

In the first instance, the 3 per cent cash rate was set during the GFC as the threat of global depression loomed, but it was accompanied by one of the biggest fiscal stimulus settings Australia has seen.

In terms of the size of that fiscal stimulus, real growth in government spending totalled 17 per cent in the two years to 2009-10. This saw government spending rise from 23.1 per cent of GDP to 26 per cent, a rise of 2.9 percentage points in just two years.

In the current environment, while the numbers await confirmation in next Tuesday’s budget, government spending has recorded approximately zero real growth in total over the last three years (to 2012-13) which has meant that the ratio of government sending to GDP has fallen to 23.8 per cent, a drop of around 2.2 percentage points. 

In other words, there is a difference of more than 5 per cent of GDP in government spending between now and the emergency action of Australian policy makers during the GFC. In today’s dollar terms, 5 per cent of GDP is over $75 billion in a single year.

The change in the bottom line of the budget was even more extreme as revenue to the government fell during the GFC. From a surplus of 1.7 per cent of GDP in 2007-08, the budget went into deficit of 4.2 per cent of GDP, a change of 6 per cent of GDP. Assuming a deficit of 1 per cent of GDP for 2012-13 when the budget numbers are updated next week, there has been a contraction in the budget bottom line of around 3 per cent of GDP over the last three years.

In other words, the bottom line change in the budget is a tub-thumping 9 per cent of GDP from the GFC stimulus measures a few years ago to the fiscal contraction now. And 9 per cent of GDP now is around $135 billion in a single year.

Does anyone still think that the low interest rates now bare any resemblance to the emergency levels that prevailed during the GFC?

The other massive difference was the level of the Australian dollar. In March 2008, the Australian dollar was trading around 95 US cents. As the crisis hit and emergency settings were in place, the dollar collapsed to below 65 US cents in late 2008 and early 2009, a fall of over 30 per cent. This helped the export sector keep its head above water at the time of global recession.

Even after yesterday’s rate cut, the Australian dollar is still around U$S1.02, down a few cents from the level prevailing earlier in the year, but whichever way one cares to cut it, the Australian dollar is still strong. It is acting a severe handbrake on economic growth right now as opposed to the stimulus it delivered in 2008 and 2009.

On the basis of the stance of fiscal policy and the level of the Australian dollar, low interest rates are being implemented by the Reserve Bank right now as it works to offset what in the current climate are factors restricting economic growth, not supporting it as was the case during the GFC.

Anyone who makes the comparison of today’s cash rate with the emergency level during the GFC has no idea about the mix of policies and is unaware of the linkages between policy settings and their impact on the economy.

If real government spending was growing by 3 or 4 per cent, it is obvious that the central bank would not have the current cash rate in place. But spending is flat to down so it does!

It would be a similar story, if the Australian dollar was 15 to 25 per cent lower than it is now. In this example, there would be a stimulus to the export sector and those firms competing with imports would also be faring much better. 

While the dollar may fall at some stage, the tight fiscal settings won’t.

This alone should be enough to see the Reserve Bank cut interest rates some more, to new fresh record lows, in the months ahead.

The futures market is pricing in a 2.25 per cent cash rate for early 2014 and on current trends, it just might be right. It is not an emergency, it is a reaction to low inflation and policy restrictiveness elsewhere.

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