Until Inflation Rises Expect Aussie Interest Rates To Remain low

Australia Economy
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The use of monetary policy has never been in the spotlight more than it has in the last few years. When new RBA Governor Philip Lowe addressed the parliament’s Committee on Economics only a week ago, it was the first thing he spoke about.

Of course, it wasn’t his first time before the committee. As he pointed out, as Deputy Governor (and in other roles), he’s been attending these hearings for over a decade.

Back when he first started attending, the official cash rate was closer to 6.0% and heading higher — hitting a then peak of 7.25% in March 2008. And inflation was higher, too. After dipping from 4% in late 2005 to around 2% in early 2007, it hit a high of 5% later that year.

For the RBA, the inflation rate is never far out of sight. The three core goals of the RBA are well known: To ‘contribute to the stability of the currency, full employment, and the economic prosperity and welfare of the Australian people.

The way the RBA sets out to achieve these goals is targeting a medium-term inflation rate; and it uses the cash rate to achieve this.

The idea is that ratcheting up rates should help curb demand and thereby take some heat out of inflation. And the opposite: That lowering rates should increase demand and help spur inflation along.

The problem for the RBA and other central banks is that it’s this second part of the equation that has stopped working.

Inflation — once considered the enemy because of its ability to erode the basis of money — is now the thing that’s proving elusive to central bankers. After spending decades getting on top of it, they now want it back again.

The battle for central bankers now is to stave off deflation.

Technically, deflation refers to an inflation rate below zero. The only way for this to occur is through a reduction in the prices of goods and services. Even if the inflation rate doesn’t fall below zero, this reduction in prices is what puts the brakes on an economy.

At first glance, a reduction in prices might seem like a good thing. Surely it would lead to an increase in demand as things become cheaper, right?

But the problem is that it acts as a deterrent. Rather than buying now, people defer purchases. They know that the items they’re looking to buy will be cheaper in the future. And that’s where the damage is done.

The reduction in demand leads to higher unemployment, which puts another dent in consumption — there is less money in the economy to share around. Those still working will be less likely to spend their money in case they too are put out of work. You can see how it can become a spiral, and why central banks will do what they can to avoid it.

The frustration for the RBA is that one way to put upward pressure on inflation — wages growth — is also falling. As Dr Lowe noted, ‘the current rate of wage growth is the slowest in around two decades.

You can see how much it is continuing to drop off in the following chart. The chart represents the annual change in hourly rates of pay, excluding bonuses.


Source: tradingeconomics.com, ABS
[Click to enlarge]

The chart above goes back to July 2013. However, it becomes even more pronounced if you take a longer term view as per the following chart:


Source: ABS
[Click to enlarge]

You can see that wages growth has more than halved over the last seven years. And it’s very similar for both the private and public sector. While companies on the ASX have been able to grow profits over the same period, a big part of that has come from containing wages.

But how long can that last? Eventually the real economy has to flow into share prices. Low wages growth puts a cap on spending — as was evidenced in the recent reporting season with so many companies struggling to grow revenues.

It’s not all bad, though. A cap on wages growth has also helped keep unemployment in check. After hitting a recent peak of just over 6% in 2014, the unemployment rate is once again trickling lower. There are still plenty of people working; it’s just that many aren’t expecting pay rises anytime soon.

With inflation stuck at 1.0%, the question has been put to the RBA about its adherence to its 2–3% inflation target. But don’t expect this to change. In his presentation to the committee, the governor reiterated this goal.

Until there are signs of inflation starting to rise again, we can expect interest rates to remain low. This will help to put a floor under demand. But until wages start to grow again, the economy will be stuck in second gear.

Regards,

Matt Hibbard,
For The Daily Reckoning

Matt Hibbard

Matt Hibbard

Matt Hibbard is Port Phillip Publishing’s income specialist. While most investors focus on making money in the short term, Matt takes a different view. He’s focussed on how you can invest today to grow wealthy in 10 or 15 years’ time. You can find more of Matt’s work over at Total Income where he’s hunting down the next generation of companies that could pay you more each year than you initially invest.
Matt Hibbard

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