It's the global economy, stupid

RBA governor Glenn Stevens will meet up with other central bankers in the US on Friday. Here's hoping they convince him how fragile the global economy is.

"It’s the global economy stupid.”

That should be the sign pinned up in the foyer of Reserve Bank offices in Martin Place Sydney to remind the central bank gurus of the most important influence over the Australian economy – global economic conditions.

In the last few months, the Reserve Bank has refused to cut official interest rates, holding them at a globally high 3.5 per cent and at the same time, senior officials have ridiculed proponents of policy action to drive the Australian dollar lower. This is an increasingly high-risk strategy as the poor economic and market news from overseas continues to flow at an alarming pace.

In China, the Shanghai Composite Index of share prices fell a hefty 1.7 per cent yesterday to be floundering at a three and a half year low. The catalyst for this latest fall was a release from the Chinese National Bureau of Statistics that showed a 5.4 per cent annual fall in industrial profits in the year to July – an accelerated fall after a drop of 1.7 per cent in the year to June.

All is clearly not well in China with reports of growing stockpiles of raw materials, a massive over supply of property and unsustainably large inventories of consumer items such as cars sitting on the wharves. The problems from the slowdown in China are also showing up in the sharp fall in commodity prices for a range of industrial inputs – coal, iron ore and copper in particular.

One likely reason for the unrelenting run of problematic news out of China is the protracted recession in Europe. The eurozone is the largest export market for China. This concentration of exports is the main mechanism through which the bleak economic news in Europe flows through to the poor export and manufacturing news in China.

There was more bad economic news from Europe last night, this time for Germany and France. The German Ifo survey of business conditions was weak.

The Ifo’s business climate index fell for a fourth straight month to record the lowest reading since March 2010.

The Ifo survey, together with last week's composite Purchasing Managers Index for Germany, has prompted JP Morgan to forecast a 0.5 per cent decline in third quarter German GDP. While such a fall is obviously bad news for Germany, it is a result that would almost certainly entrench the whole eurozone in recession for yet another quarter.

Until now, Germany has been the foundation stone for the eurozone. Germany’s economic performance has been reasonable amid of sea of euro area recessions as its exporters have enjoyed the competitive boost from an undervalued euro.

That foundation appears to be crumbling.

In France, the number of registered unemployed rose to 2.987 million in July, a level that is likely to see the unemployment rate move above the current 10.1 per cent which is already a 13 year high. These trends are not only poor economic news, but they make repairing the fiscal position more difficult. This fiscal challenge in France has caught the eye of credit rating agencies and markets seem ready to pounce given France’s fiscal position shows no signs of improving.

With the French and German economies deteriorating and most of the peripheral countries in the eurozone already floundering in recession, the threat to the global economy is getting more intense.

The sovereign debt problems have not been addressed. The Greek debt problems and the associated bail out will be the focus of markets in the next month.

In a new twist to the increasingly heated debate about how to fix the eurozone problems and then hold it together, French President Francois Hollande, a key player in the agenda, is controversially suggesting that Europe needs to move towards fiscal union as a means of mutualising government debt. This, no doubt, will meet resistance on many levels.

The world’s central bankers are meeting in Jackson Hole on Friday and over the weekend. It will not be a fun gathering. The central bankers will no doubt be comparing notes on what to do given the backdrop of economic weakness, chronically high unemployment, low inflation and unsustainable levels of sovereign debt.

There is chatter in the markets, which is not at all surprising, that following the Jackson Hole meeting, the world’s central bankers will implement some form of coordinated monetary easing – be it more quantitative easing in countries that cannot cut interest rates below zero, or some other form of monetary stimulus.

This seems a bare minimum given how the world economy is performing.

It will be interesting to see whether our own Glenn Stevens comes away from Jackson Hole with a glass half full view of the world or whether the gloom from his central bank counterparts leads him to think that the current level of interest rates in Australia is too high. Already, there is a good case for the Reserve Bank to cut interest rates if for no other reason than the stunningly low rate of inflation and the prospects that low inflation continues for some time.

A dose of gloomy global news might bring Stevens across the line. Get set for more interest rate cuts in the months ahead.

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