Caton's Corner - October 2013

It was a busy month. Early on, of course, the Australian election went much as expected. While there does appear to have been a noticeable lift in both business and consumer confidence, it is hard to discern a market effect. This should not be a surprise election results usually have little effect, especially when they are so well anticipated.

In mid-month, the Federal Reserve surprised almost everyone by not beginning its much-heralded “taper” of quantitative easing (QE). We have written about this before and will not repeat the main considerations here. Suffice it to say that analysts have taught themselves that QE has been good for the share market and hence that any sign it is ending must be bad. I have made the point in the past that this is overly simplistic an economy that is growing well enough not to need further QE is surely a better environment for the market than one still limping along and hence in need of continuing QE.

It is possible that the Fed decided not to begin the taper because it was concerned about market reaction. If this is the case, we may have a Hotel California problem. The Fed may want to check out, but find itself unable to leave QE. The taper may now not begin until early-2014, in the reign of a new Fed chairperson.

The end of the month brought another development. The US government moved closer to a shutdown. The new fiscal year begins on 1 October. At time of writing, the government is without a Budget and, more importantly, without a continuing resolution that would enable it to keep functioning. If nothing is done, all bar essential operations will shut down. This is not as dire as it sounds. First, only the 36% of Federal spending classified as “discretionary” is affected Social Security payments, for example, continue to be made. Second, while there hasn’t been a shutdown since the halcyon days of Bill Clinton in 1996, before that they were quite a common occurrence. The table shows that there were 17 such shutdowns between 1976 and 1996. The median length was 3 days, with the longest being the 1995-96 event (21 days). Ominously, those that began on 30 September, as this one will if it eventuates, had a median length of 11 days. In each case, life as we know it eventually resumed.

There is another related issue. The US is again approaching its debt ceiling, with the Treasury Secretary warning that the government will run out of money around 17 October (later, one imagines, if there is a shutdown!). This has again become a political issue—recall the farce in August 2011—with the Republicans threatening to withhold consent unless the health care package, known as Obamacare, is defunded. Obamacare is also being held hostage in the shutdown negotiations. The President is resisting fiercely. Given that Obamacare was and is his hardest-won policy accomplishment this is scarcely surprising.

There is no question that a US shutdown will add to the volatility of markets, but it is unlikely to be an ongoing depressant in my view. After its record high when the Fed announced no taper, the S&P500 index fell in seven of the next eight sessions, by a total of 2.5%.

Domestic News

Early in the month, the RBA opted not to cut the cash rate further from its current record low of 2.5%. A few days later, we got news of another weak labour-market report. Employment was reported as falling in August, for the second month in succession. It now stands below its February level. The unemployment rate rose to 5.8%, the highest it has been since June 2009.

There were two other major developments pertaining to the likely future of monetary policy. First, surprisingly, the exchange rate rose significantly. Having begun the month at 89.5 cents, it rose to 94 cents in the aftermath of the non-taper, finishing the month at 93.1 cents. The RBA has suggested several times that the strength of the currency has been holding back the Australian economy, and would not have greeted this rise with joy.

The “left field” event of the month was the sudden concern about house prices. In the minutes of the early-month Board meeting, the RBA noted that borrowing to purchase property within self-managed super funds may be becoming a little cavalier, a “shot across the bows” that was re-bruited in the RBA’s regular Financial Stability Review. In addition, house prices are now outpacing income growth in at least some capital cities while auction clearance rates are on the rise. Suddenly the words “house price bubble” became far more frequent.

House prices have very little weight in the CPI, the measure of inflation targeted by the RBA. But the RBA does pay attention to them, and is well aware that low interest rates run the risk of inflating asset prices. But rising prices alone do not constitute a bubble.

Contrast the current situation with that in 2009-10. According to ABS data, nationwide prices in the June quarter this year were 5% higher than three quarters earlier (they have, of course, risen more since then). In 2009-10, they rose by more than 20% over five quarters, fuelled in part by the doubling of the First Home-Owners Grant. In early-2010, the RBA Governor appeared on breakfast television to warn that the RBA was watching house prices closely. This year, Assistant Governor Malcolm Edey said that current talk of a bubble was “unduly alarmist”. He pointed out, correctly, that dwelling prices have risen no faster than income over the past decade. Bubbles are usually characterised by rapid growth in lending for housing, and by clearly speculative behaviour neither of these is currently a factor. Indeed, housing credit has increased by just 4.7% in the past year, up only slightly from a record low 4.4% earlier this year. This figure is being held down by borrowers repaying ahead of schedule, and it also doesn’t include the effects of “cashed-up” buyers, but it’s a long way from bubble territory and certainly indicates no massive loosening of lending standards.

But while there is no bubble at present, continued low interest rates increase the chance of one in the future. The RBA is well aware of this, and house prices are in the “against” column when the Bank weighs up whether to cut rates even further.

If we do get another cut, it will be because the unemployment rate has gone through 6% with some velocity, or because the exchange rate rises further. I made the point last month that the cutting cycle may be at an end, and I see no reason to change that view.

Chris Caton
Chief Economist

The views expressed in this article are the author’s alone. They should not be otherwise attributed.