How the RBA got it wrong on rates

For months, the Reserve Bank of Australia has signalled that rates will remain unchanged for some time, but is that really the most appropriate course of action?

With growing signs that momentum slowed during the June quarter, and mounting headwinds on the horizon, the Australian economy needs a kick in the butt to ensure that it doesn’t topple over when mining investment collapses.

Back in May, the RBA noted “there is significant uncertainty as to whether the timing of stronger activity in some parts of the economy will coincide with weaker activity in other parts”. That is the crux of the issue facing the RBA: despite its best efforts, it hasn’t got the timing perfect and there is growing evidence that the economy has peaked too early and may be poorly placed as mining collapses over the next two years.

Household spending has, until recently, been fairly strong. Low interest rates have lowered mortgage and credit card repayments and boosted households' discretionary spending.

Unfortunately, the outlook has soured quickly. With a subdued labour market and consumer confidence plummeting, the outlook for household spending is far from pretty. Add in declining real wages and budget cuts that target those with the highest propensity to consume, and it begins to look ugly.

Without further stimulus, household spending appears poorly placed to support the economy over the next couple of years. The budget forecast for consumption growth of 3 per cent in 2014-15 appears increasingly off the mark.

Residential investment increased sharply in the March quarter and will likely remain elevated throughout 2014. But the construction boom -- and I use that word lightly -- appears set to be fairly short and inconsequential.

Building approvals, a leading indicator of residential investment, have declined by almost 15 per cent over the past three months. At only 3 per cent of real GDP, residential investment is much too small to provide a genuine long-lasting boost to GDP growth.

Housing construction occurs with a fairly lengthy lag, which suggests that residential investment may still be growing at a solid pace well into next year. In this regard, housing construction may provide some modest relief from the collapse in mining investment.

It should be clear that neither household spending nor housing construction is sufficient to offset the collapse in mining investment. Certainly the RBA shouldn’t expect any support from the federal government, which has actively dampened consumer demand through cuts that target those who spend most of their income.

This leaves us with exports or, in other words, China.

As a result, the outlook for rates largely depends on whether China will slow and whether the iron ore price will rebound. 

The Chinese economy continues to grow strongly (at 7.4 per cent over the year to the March quarter) but there are growing concerns about its property and financial markets. Its economy remains somewhat of a ‘black box’ ,even to those within the country, but if it does continue to rebalance its economy away from investment (driven by demand for Australian iron ore), then this will inevitably weigh on Australian exports and growth.

The iron ore price has declined significantly throughout 2014 on the back of more iron ore projects transitioning to the production stage. Coupled with slowing steel demand from China and the outlook for iron ore prices is fairly bleak.

Export volumes should remain high, at least in the near-term, but a softer iron ore price will weigh on the amount of goods Australians can purchase from those exports. However, strong export growth won’t feed through to consumption growth, as it did when our terms of trade was on the rise.

The RBA may be happy to wait right now but there is growing evidence that it's got the timing wrong. Household spending is beginning to slow and the Chinese economy is looking a little shaky. The third pillar of growth (housing construction) is fairly inconsequential and unlikely to contribute significantly to growth over the next few years.

Interest rates may be too blunt an instrument to successfully navigate the end of our mining boom but that is the best we currently have. With momentum slowing across the economy and a fairly bleak outlook for the household sector, the economy needs a further boost. The RBA should respond with another couple of cuts later this year.