The Reserve Bank should have cut interest rates a couple of months ago, but its pig-headed and increasingly misguided optimism on Chinese growth, the mining boom and high commodity prices overwhelmed news of ongoing low inflation, a softer labour market and faltering global economic conditions.
The RBA board has a chance to make up for this misreading of economic conditions by cutting interest rates today. There is now a run of data and economic news longer than RBA Governor Glenn Stevens’ arm that points to inflation staying extremely low, which validates the urgent need for a 25 basis point rate cut.
The global economy continues to disappoint with growth downgrades as a regular occurrence. That softer global growth impacts on Australia through sentiment, which is subdued, and through lower commodity prices and weaker export receipts and weaker income growth.
This is troublesome enough as it is.
Normally in these circumstances, the Australian dollar falls more or less in lock-step with commodity prices as it acts as an automatic stabiliser or shock absorber for the economy. This time, however, the Australian dollar has been resilient – in fact it is higher now than it was in November last year when the Reserve Bank started the monetary policy easing cycle and this is despite the fact that commodity prices are 18 per cent lower.
The Australian economy is under pressure from the weight of the high and overvalued dollar, which is crimping growth and helping to drive inflation to a rate lower than is desirable. It looks like underlying inflation will remain near 2 per cent for the near term. A further easing in monetary policy would help offset the restrictive influence and disinflation pressures from the strong currency. It might, at the margin, also erode some of the misguided support for the dollar, which would be welcome by the trade exposed parts of the economy.
But there are other important reasons that will be argued today to support an interest rate cut.
Credit growth is extremely weak, perhaps weaker than a period of reasonable deleveraging would suggest. Housing credit growth has dropped to its lowest level ever recorded (data back to 1977) as a sign consumers are scaling back on borrowing and are using their rising incomes to reduce debt. While some deleveraging is good when debt levels are high, too much risks undermining growth.
The position of the labour market is open to debate. The latest data showing the unemployment rate at 5.1 per cent suggests the economy is buoyant and works against an interest rate cut. Indeed, one reason for the Reserve Bank’s tardiness in cutting interest rates is linked to the unemployment rate staying around 5.25 per cent for the past two years. A closer look at the labour force data shows employment has dropped 27,000 in the last three months, hours worked are falling and the participation rate is down. All of these point to growing slack in the labour market and a steady move away from full employment. The fact that the number of job ads measured by ANZ Bank has fallen for half a year is also a dead give-away that it is the jobs decline and not the unemployment rate that is painting the clearer picture of the state of the labour market.
It is also important to note that Treasury Secretary, Martin Parkinson, is on the RBA board. He will bring to the table the general themes of the government’s approach to fiscal policy in the soon to be released Mid-Year Economic and Fiscal Outlook document. Based on the recent comments from Treasurer Wayne Swan and Finance Minister Penny Wong, there will be a raft of spending cuts delivered in the quest to return the budget to surplus. This will strip money out of the economy, meaning that easier monetary policy is needed to offset what will be the biggest fiscal tightening Australia has ever seen.
The fact that the state governments in Queensland, New South Wales and Victoria are also embarking on a range of spending cuts only adds to the size of the subtraction from GDP growth from public demand.
These factors point to subdued underlying inflation continuing over the forecast horizon. Already, annual underlying inflation is running at 2.0 per cent (headline inflation is 1.2 per cent) which is a 13-year low. Recall that the RBA has a target for inflation of 2 to 3 per cent over the cycle, a target it has met with aplomb for most of the last 20 years. With the current read on economic risks, there seems to be little prospect of inflation approaching the top half of the band even with more accommodative monetary policy.
Indeed, there seems to be a significant risk of underlying inflation falling below the bottom end of the target if monetary policy is kept too tight for too long and the Australian dollar remains over-valued.
There is one minor glitch to the issue of rate cuts and that is the recent uptick in house prices. Since the end of May, house prices have risen by 3 per cent – in isolation a reasonable rise. A further interest rate cut may underpin further upward house price moves. For the moment, this looks to be an issue of low importance – the 3 per cent rise in house prices followed almost 18 months where house prices fell around 7 per cent. House prices are therefore around 4 per cent lower today than they were in early 2011. And in any event, the Reserve Bank does not target house prices nor does it have a strong disposition to use monetary policy to deal with changes in asset prices.
Whatever happens today, the market has a cash rate of 2.5 per cent or in fact a little less priced in to the middle of 2013. Either the market is wrong – which I doubt – or the Reserve Bank has a lot more cutting to do as it sets policy with an eye to underpinning ongoing solid growth with low inflation.