Last week the RBA cut the overnight cash rate by a further 100 basis points to complete the most aggressive three-month rate cut cycle we have seen since the Bank started announcing target cash rate levels in 1990. Even when the starting point was 15 per cent and the unemployment rate had already deteriorated from 5.5 per cent to 7 per cent it still took eight months to get to 12 per cent; another 11 months to get to 8.5 per cent; and another eight months to get to 5.75 per cent.
The issues are clear. The Bank is seeking to get ahead of the curve on this occasion in an attempt to provide sufficient stimulus to incomes and confidence to avoid a disastrous collapse in demand that would inevitably lead to a severe contraction in employment. With household debt levels at such excessive levels a sharp deterioration in the unemployment rate would probably trigger sharp falls in house prices and Australia would be in the nasty deflationary cycle which is currently afflicting the US, UK and parts of Europe.
Monetary policy is being complemented by fiscal policy in this coordinated policy effort. The Commonwealth budget surplus is forecast to narrow from the $19.7 billion outcome in 2007-08 to $1.6 billion in 2008-09. That is a fiscal stimulus of around 1.7 per cent of GDP – the largest fiscal stimulus since 1991-92 when the government allowed the budget to move from a position of balance to a deficit of 2.8 per cent of GDP. The deficit then widened in the following year to 3.9 per cent of GDP which was similar to the low point of a 3.3 per cent of GDP deficit in the early 1980s recession. Accordingly there is ample scope for the fiscal authorities to provide further stimulus if it appears that the current stance of policy is insufficient to achieve an acceptable level of demand.
In that regard there were some important messages from the September quarter national accounts. They showed that GDP expanded by only 0.1 per cent and non-farm GDP actually contracted by 0.3 per cent. Of most concern was the anaemic 0.1 per cent increase in consumer spending following a 0.1 per cent contraction in the June quarter. This was despite the $7.1 billion tax cut which was phased in from July with around $1.8 billion being released in the September quarter; along with a solid 2.2 per cent increase in wage incomes.
Clearly consumers increased their savings in the September quarter, with the savings rate rising from 1.3 per cent in the June quarter to 3.9 per cent. It appears that households saved virtually all of the increase in incomes in the September quarter. That behaviour is consistent with the very weak reads for consumer sentiment during that period, at a time of record high petrol prices. It explains why retailers have been so adversely affected. Supporting evidence for this behaviour is the increase in housing equity in the September quarter, with our estimate that households injected around $7.5 billion into housing equity – the biggest proportion of income since the September quarter 1998.
Notwithstanding the tax cuts, a significant stimulus to household incomes will arrive in the December quarter. We estimate that the cumulative rate cuts will add around $6 billion in lower interest payments in the December quarter and when combined with the $8.4 billion fiscal payment will swell household incomes by $15 billion.
Saving all of that stimulus would boost the savings rate to 11.7 per cent - an entirely unrealistic prospect. However, we do estimate that the savings rate could rise to around 7.5 per cent which would imply that households spend around $3.5 billion of the income stimulus. That would be enough to keep GDP growth in positive territory over the three quarter to June 2009, although growth would be painfully weak and certainly not sufficient to stop the unemployment rate rising towards 6 per cent through 2009.
With such a muted response from households to the massive stimulus the RBA would probably be disappointed. It would also raise the question as to what stimulus can be applied to the economy through the remainder of 2009 to stop demand growth lapsing back to the anaemic pace we saw in the September quarter.
The easy part is probably that both the RBA and the government (assuming it can deal with its concerns about a deficit) will be disappointed with such a large jump in the savings rate and see the need for further stimulus early in 2009. The more difficult part is what happens from the June quarter, when markets and forecasters have generally forecast an end to the stimulus policies.
The expectation is that credit, housing approvals, confidence, and wealth (indicated by the share market and house prices) will start to show some stability.
However, there remain huge risks around that scenario. The commitment of households to pay down debt that we saw in the September quarter may be stronger than we currently expect; the modest response to the massive stimulus may unnerve confidence in the housing market; and the nasty (-5.4 per cent) collapse we saw in dwelling approvals in October may be signalling a tighter credit environment (particularly for multi-dwelling buildings) than we have been expecting. Certainly, the 50 per cent slump in office approvals that we have seen in the last six months is set to extend through all of 2009.
In those circumstances I have little doubt that the RBA will accept the need to extend the stimulus process. Our current target of a low point of 3.5 per cent in the cash rate by March will be left far behind.
With the major central banks of the world all flirting with zero policy targets by the June quarter of next year, the RBA should have little hesitation closing the gap to considerably less than the 3 per cent which would be implied by our 3.5 per cent current expectation.
Additionally, it would be extraordinary under those circumstances if the government did not play a complementary role as it has in the current period. That would ensure a significant deficit given the current figuring. Current official estimates - following the
additional $3.5 billion payments to the states for health and education - suggest a surplus of $1.6 billion in 2008-09 and a surplus of $1.8 billion in 2009-10.
That implies that the government is now forecasting a fiscal TIGHTENING in 2009-10. That would be an extraordinary policy stance given that there is an obvious need for fiscal policy to remain stimulatory. In this environment when stimulatory policies are mandatory, to run a surplus is inappropriate. The obvious implication is that we will see additional policy measures announced between now and the next budget, as well as on Budget night, 12 May 2009.
In short, a budget deficit is inevitable and desirable, if not in 2008-09 then certainly in 2009-10. We anticipate that the need for fiscal policy to continue to complement monetary policy during this difficult period will become the accepted wisdom.
Bill Evans is chief economist at Westpac.
Households remain extremely nervous about spending and further fiscal stimulus measures will be needed to kick-start the economy. A Federal Budget deficit is inevitable and desirable.
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