Cutting rates to zero

The Reserve Bank shouldn't have cut rates given the strength of the economy. If it chooses to ignore current data then, hypothetically, interest rate cuts could go on indefinitely.

The Reserve Bank’s decision to cut 25 basis points yesterday is clearly one I disagree with. I don’t think it was a good decision at all or warranted on any metric. In my opinion they are cutting unnecessarily and, in fact, completely overdoing it. But that they were going to cut at some point was well flagged so I don’t think it’s a surprise to anyone. All economists, unfortunately myself included, were prepared for another cut at some point and, as I’ve argued for some time now, every meeting is live.

So now we have a cash rate that is only 25 basis points above its GFC trough. Assuming other banks follow the Bank of Queensland, variable mortgage rates will be cut by 20 basis points to bring them to their lowest point since the global financial crisis at around 5.8-5.9 per cent (average through GFC was 5.4 per cent). Three-year fixed rates are even lower than that. Lending rates are clearly very stimulatory.

While another cut was expected at some point (most economists tipping next month) the statement offered no real smoking gun as to why they cut rates again at this meeting. Indeed the press release had little that was new compared to last month. The Bank’s view on global growth was little changed and the board suggested that "the world economy had softened over recent months” although I’d note that has yet to be backed with hard data.

It is the perception though. It wasn’t a material downgrade by the looks and their statement on commodity prices and the terms of trade was little changed as well. They noted that commodity prices had weakened considerably, but again, they pointed out that the terms of trade remained historically high.

It was their assessment of the domestic growth situation that really caught my eye and there were some changes here.

The Reserve Bank, with no evidence whatsoever, has effectively called the end of the mining boom. People point to the fact that commodity prices have fallen. But this isn’t an argument, it’s an observation. Prices could equally rise again. I know they’re not the first to call it but this is a very reactive statement. Consequently they now suggest that it’s important to see other components of demand lift – presumably that’s why they cut rates.

Now there are several things to note here. Other components of demand have already lifted and indeed are growing at strong rates. Consumer spending has actually been strong for some time, and further interest rate relief is unlikely to materially impact this – car sales are already at a record, for example.

I can only assume they are targeting a pickup in construction then – residential and non-residential. Knowing a number of developers though, I can tell you it’s not the price of money that is holding construction back. Everyone in the industry knows this, so I’m not sure what the RBA’s game is.

The bigger question now is where/when do they stop. A question not easily answered given policy decisions are not based on economic fundamentals. Instead, the Reserve Bank Board has opted to cut on forecasts or assessments of growth that have proven to be incorrect. The decision to cut in May/June was predicated on domestic economic weakness, the same as the November/December cuts. These forecasts were shown to be wrong and growth in fact has been significantly stronger than the RBA forecast.

That they cut again yesterday goes to show they don’t care about that fact. And this is the worry, because that that process can go on ad nauseam – so theoretically zero is the limit. You just keep forecasting weakness despite strength.

So with only strong data and weak forecasts to go on, we truly have no signposts – actual data is repeatedly being ignored. Moreover, blatant falsehoods are bandied around recklessly. So for instance the RBA implies that consumer spending was strong in the first half of this year, partly because of carbon compensation. This is demonstrably untrue.

I suggested back in 2011 that the key signposts for the trough were sentiment, or political factors – the feel god factor if you will. Realistically, the trough in the cycle will be reached when the government, retailers, manufacturers and unions, cease asking for them. But we don’t know what that point is, the economy is already strong. Moreover, the Australian dollar isn’t going to come down on a sustained basis, the housing sector isn’t going to surge while the global situation remains uncertain. On that basis, there’s a good chance that vested interests will want to keep pushing rates toward the zero bound.

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