Is the Interest Rate Injection Running Out?


The all-wise and knowing board of the Reserve Bank of Australia met yesterday and felt that the price of credit in Australia was just about right. Official interest rates remain at 2.5%. The accompanying statement suggests they’ll stay there…until something changes. That is, there was no easing or tightening ‘bias’ for the market to hang onto. The Reserve Bank of Australia is on ‘hold’.

They’re waiting. Waiting for the effects of the last round of rate cuts to work their way through the economy. Here’s the RBA’s hope paragraph (our emphasis):

The easing in monetary policy that has already occurred since late 2011 has supported interest-sensitive spending and asset values. The full effects of these decisions are still coming through, and will be for a while yet. The pace of borrowing has remained relatively subdued overall to date, though recently there have been signs of increased demand for finance by households. There is also continuing evidence of a shift in savers’ behaviour in response to declining returns on low-risk assets. Housing and equity markets have strengthened further over recent months, trends which should in time be supportive of investment.

That sentence that we’ve underlined sums it all up. The RBA firmly believes in the doctrine that higher asset prices will lead to higher investment in the real economy. That’s despite all the evidence pointing to a different outcome. Australia, with some of the highest property prices in the world, has a supply shortage.

That’s telling you there is a lack of investment in housing. No, it’s telling you there is a lack of investment in NEW housing. Most of the easy money is going into the existing stock of housing. So the RBA can sit back and pump asset prices higher and hope that investment follows. But it won’t. And it won’t because monetary policy is almost impotent in a sector retarded by poor incentives and tax structures.

Sure, the recent rate cuts are going to have a short term inflationary impact on the sector. You’ll see a relative increase in investment. But then the inflationary tide will recede and the industry will once again be screaming for easier money to boost investment.

Let’s see how long it will take…

The easing cycle began two years ago, with rates falling 0.25% to 4.5% in November 2011. Another 0.25% cut followed in December. Then in May 2012, the RBA reduced rates by 0.5%, followed by a 0.25% reduction in June, October and December. 2013 saw two reductions of 0.25%, in May and August.

Apparently it takes about a year for the effects of easy money to flow through the system, although no one really knows. If that’s the case, the vast majority of the inflationary boost to the system has already flowed through the economy. We’re at the tail end of it right now.

That is, from November 2011 to December 2012, the RBA cut rates from 4.75% to 3%. Working on the assumption that it takes a year to work its way through the system, give or take a few months, by early 2014 that stimulus will have worn off.

According to our calculations, over 75% of the easing cycle is in, moving through, and now moving out of the system. There are just the two 2013 rates cuts still in the pipeline. We’re not sure about this, but our guess would be that interest rate stimulus becomes less effective the lower that rates go.

That’s because the very fact that interest rates are so low means nearly anyone who had an intention of borrowing has already done so. The lower they go, the lower the quality of creditors coming in the door looking for a loan. It’s questionable just how willing the banks would be to accommodate an influx of poor quality creditors.

Anyway, if we’re right on this don’t expect monetary policy to lead to an economic rebound in 2014. Expect a ‘confounding’ slowdown in the housing market, and a weak economy in general, leading to more cries of easy money as the addicts become restless. 

Speaking of a weak economy, today we get September quarter economic growth data from the Australian Bureau of Statistics (ABS). As we write this, it’s not out, so we’ll comment on it tomorrow. But one weird aspect to the report was yesterday’s balance of payments data, which showed that a positive trade balance for the quarter will contribute 0.7 percentage points to the economic growth figure.

The positive trade balance for the quarter was $8.5 billion dollars. At least it was in ‘seasonally adjusted, chain volume terms’. The ABS adjusts imports and exports to remove the effect of price changes so it can estimate the real value of the nations’ production. So in terms of volumes our trade performance was good.

But in the same release, the ABS tells us that Australia’s current account deficit blew out to a seasonally adjusted $12.7 billion in the September quarter. And $2.57 billion of that was due to a goods and services deficit!

We don’t understand how price changes can account for such a large discrepancy. If anyone has any ideas, please let us know!

The current account deficit is a combination of our trade performance and what is known as our net income deficit. Because Australia has net foreign debt of $829 billion, and net foreign equity of $25 billion, there is an interest and earnings outflow every quarter, to service the debt. Despite falling interest rates, the outflow is not improving. The September quarter saw $9.6 billion in net income payments, making up the bulk of the current account deficit.

The reason why the current account deficit is not improving is because our foreign debt keeps growing. At the start of the GFC, in the September 2008 quarter, net foreign debt stood at $658 billion.

Since that time, despite the biggest surge in national income in history, Australia still managed to add a net amount of $171 billion to our foreign debt pile.

The bottom line is that foreigners still overwhelmingly fund our standard of living. And they will continue to do so, at least in the short term, given our exposure to China and Asia. But if China experiences a ‘credit event’, which we think is a higher probability than most people think, then foreigners views of Australia will change markedly.


Greg Canavan+
for The Daily Reckoning Australia

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Greg Canavan
Greg Canavan is the Managing Editor of The Daily Reckoning and is the foremost authority for retail investors on value investing in Australia. He is a former head of Australasian Research for an Australian asset-management group and has been a regular guest on CNBC, Sky Business’s The Perrett Report and Lateline Business. Greg is also the editor of Crisis & Opportunity, an investment publication designed to help investors profit from companies and stocks that are undervalued on the market. To follow Greg's financial world view more closely you can subscribe to The Daily Reckoning for free here. If you’re already a Daily Reckoning subscriber, then we recommend you also join him on Google+. It's where he shares investment research, commentary and ideas that he can't always fit into his regular Daily Reckoning emails. For more on Greg go here.

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