Soon-to-be strength will quell a cutting spree

Yesterday's interest rate cut may signal the end of the Reserve's easing cycle. A falling Aussie dollar, increasing house prices and a stronger global outlook will make it hard to cut again.

It can be foolhardy to call the end of an interest rate cutting cycle less than 24 hours after the Reserve Bank has delivered an interest rate cut, but there are a few issues emerging that will make any more cuts difficult for the central bank to deliver. 

Having been a strong critic of the Reserve Bank through 2011 and 2012 for being too slow to cut interest rates, I made the mistake in January 2013 of calling an end to the rate cutting cycle with a strong global economic backdrop a key reason for that view. Persistently strong jobs data and the low unemployment rate only added to my view that the Reserve Bank would not cut again (Why rates have no further to fall, Jan 22). 

This was a classic example of premature extrapolation where a couple of good numbers did not make for a trend.

Thankfully I changed my view back in April when it was clear China was unexpectedly slowing, the Australian dollar was not matching the fall in commodity prices and inflation was set to remain stunningly low. This proved to be a good call (Read between the lines for a rate rewind, Apr 17). 

I have held my view that more interest rate cuts were needed until yesterday’s announcement from the Reserve Bank.

At the moment, there is some tentative evidence that the past interest rate cuts – and other influences – are working to see the economy lift from what is a mini-slowdown.

The Australian dollar is down a tidy 10 to 15 per cent from the recent peak, a sure sign of a boost to international competitiveness, especially given that commodity prices have stabilised. Some early signs of the effects of the lower Aussie dollar are coming through already with the trade data for June released yesterday showing a monthly trade surplus of $602 million, which was the fifth straight surplus. Expect exports to be a significant driver of economic growth over the next 18 months. Rate cuts to offset the Aussie dollar’s strength are no longer needed.

A critical aspect of the recent budget update, which has copped so much attention in the heat of the election campaign, is the fact that the influence of government demand on the economy has changed markedly from 2012-13 to 2013-14.

Public final demand fell 1.5 per cent in 2012-13, slicing 0.5 percentage points from GDP in the process. This quite extreme fiscal consolidation at both the Commonwealth but also the State government level is one reason why GDP growth slipped below 3 per cent. In the year ahead, 2013-14, public final demand will rise 0.75 per cent, which will add around 0.2 percentage points to GDP growth. This is a big shift that will add to bottom line GDP.

While the Reserve Bank does not target asset prices, it does get antsy about a sharp lift in house prices and on that score, there is clear evidence that prices are on a march higher. In the last two and a half months, house prices have risen by 4 per cent and are on track for a 10 per cent gain this year. With interest rates at levels never before seen, further house price gains are likely, if not certain. Moderate house price gains are acceptable in the mind of the Reserve Bank, but if the trend becomes too strong not only will there be no more rate cuts but the Reserve Bank would start to figure in hikes.

Other indicators are showing consolidation or gentle increases. Housing construction is trending higher, business expectations are off their lows and consumer sentiment is a little above its long run trend. Credit growth has also ticked higher. With the new low level for interest rates and the Australian dollar and any uncertainty associated with the election soon to pass, these indicators will continue to lift over the medium term.

The global economy is also on the improve with the US, Japan and even the eurozone looking better now than even a few months ago. While China and India are slowing, hard landings seem unlikely given the proactivity policy stance in both countries.

In all of this, the Reserve Bank is made up of mere mortals – they often misread the economy. This is not to say the decision to cut interest rates was wrong – it wasn’t. It is just a way of saying that the pressures on monetary policy can change very quickly and with it, the whole monetary policy direction can also change.

In September 2011, the Reserve noted after its monthly meeting that “the board remains concerned about the medium-term outlook for inflation” and that “productivity growth was weak”. Within a couple of quarters, inflation was cascading to near record lows, productivity was on a roll and the central bank played catch up with a series of interest rate cuts that almost no-one expected.

This is a round-about way of saying, pay close attention to what the Reserve Bank is saying, but don’t take it all as gospel. The Reserve can and does change its view and I suspect it will before year end when it will be looking at stronger growth, a stable unemployment rate and maybe higher inflation. This is why we have probably seen the last rate cut for this cycle.