WEEKEND ECONOMIST: Surprise party

The Reserve Bank Board meets on November 4 – Tuesday of next week. The results of the meeting will be announced at 2:30 pm on that day. That is a curious time since it is a public holiday in Melbourne and most of the Sydney market would normally be in party mode attending Melbourne Cup functions. Maybe it is appropriately symbolic given the current market travails, but when conditions return to stability the risk of major decisions impacting markets when liquidity is abnormally low must be assessed.
Possibly it is best for the Bank to move the November meeting to the first Wednesday of the month to avoid this risk. Certainly the markets are quite comfortable with Fed decisions coming out on Tuesdays or Wednesdays depending on the length of the Fed meeting.

Despite a little sabre rattling from RBA officials (latest was a comment from Deputy Governor Battellino on October 30 that high inflation could limit room for manoeuvring on monetary policy) we expect that the Bank will lower the cash rate by a further 50 bps to 5.5 per cent next week. That will still leave policy in the 'contractionary' zone. We expect that the Bank is committed to at least moving policy into the upper end of the 'expansionary' zone.

Note that the stance of policy should be assessed on the basis of the variable mortgage rate. Despite the recent 'independent' 25 bps rate cut by the banks the mortgage rate is still 50 bps higher than would have been the case if the banks had passed on all RBA cuts in full and had not raised rates independently earlier in 2008. That puts 'neutral' at 5 per cent rather than our previous estimate of 5.5 per cent. Our forecast low point for this cycle is 4.5 per cent – 50 bps below 'neutral' – the upper end of the expansionary range.

Recall that in the easing cycle in 2001 rates bottomed out at 4.25 per cent – 125 bps below 'neutral' despite housing credit growth at the time running at an annual pace of around 15 per cent. All the signs were there at the time that a housing boom was building yet the Bank chose to push rates well into the expansionary zone. Of course the main difference is that in 2001 inflation was apparently well contained with underlying inflation settling at 3 per cent in September 2001 – well below today's 4.7 per cent.

However the world outlook was much clearer back in December 2001 than it is today. Financial markets were functioning; banks had adequate capital; corporates were recovering from the dot com bubble and there was a whole lot more certainty in the world than we see today.

The way we see the RBA's thinking at the moment is that they are focussed on avoiding a recession. If the economy does lapse into recession then inflation will almost certainly collapse anyway. Consider for example the behaviour of inflation during the last recession in 1989-1991. Inflation fell from 6 per cent in the year to December 1990 to 2 per cent in the year to December 1992. The Governor effectively cut himself six months to deal with recession risks when he forecast that inflation would not start falling until 2009. The first read on inflation in 2009 will not print until April 22 providing adequate scope to move rates below neutral in the first few months of 2009 without being constrained by a recalcitrant inflation rate. We are not big fans of the recession or no recession debate.

The 'official' definition of a recession is two consecutive quarters of negative GDP growth. Arithmetically that is possible in the first two quarters of next year. The $10.4 billion fiscal stimulus ($8.7 billion in direct payments to be received on December 8) is likely to provide a substantial boost to spending. Our estimate which has been given some support from a survey by the Australian National Retailers Association is that consumer spending in December will be boosted by around 2 per cent. With a 'core' 0.2 per cent increase we estimate that consumer spending will rise by 2.2 per cent in the December quarter with a further but much more modest boost in the March quarter. With consumer spending representing around 60 per cent of GDP, growth in the December quarter is likely to be around 1.6 per cent.

In the March quarter consumer spending is likely to be lower than the one off boost from the December payout. We estimate that consumer spending will contract by 0.3 per cent in the March quarter with GDP growth being zero. An even bigger response to the stimulus in the December quarter could easily see GDP growth printing negative in the March quarter. The June quarter is likely to be the low point in this growth cycle. We are forecasting 0.3 per cent growth in the June quarter. That means two consecutive quarters of zero and 0.3 per cent growth and the margin for error could certainly mean two negative growth quarters. But the main reason would be the bringing forward of spending into the December quarter rather than a recession. The best way to look at the December/March quarter period which will benefit from the fiscal stimulus is to average the 1.6 per cent in the December quarter across the two quarters – keeping growth well out of the 'recession' zone.

Our real definition of a recession is a marked increase in the unemployment rate (at least 3.5 ppt's). Between December 1989 and December 1992 the unemployment rate rose from 5.6 per cent to 10.9 per cent and did not return to 5.6 per cent until July 2004. It took nearly 12 years to undo the damage to the labour market that was inflicted over a relatively brief period – that is a recession and the scenario that the authorities will be earnestly seeking to avoid.



The chart above shows the relationship between demand and employment growth. Australia has only had two recessions in the last thirty years. Both were partly associated with policy failures. It is clear that recessions which are marked by extended contractions in demand growth are also associated with sharp contractions in employment growth and the resulting jump in the unemployment rate. As we have discussed in earlier notes, policy has to play a proactive role in holding up demand growth. That is best achieved by boosting household disposable income through fiscal stimulus (including tax cuts); significant interest rate cuts (certainly shifting policy to expansionary zone) and accelerated infrastructure spending.

Bill Evans is chief economist at Westpac