The Chances of a Rate Cut Rise, But Its Effect Remains Questionable

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Getting mainstream economists to agree on anything is never an easy task. Getting them to reach a consensus on the Reserve Bank’s rate policy is like pulling teeth.

That’s not to say that Tuesday’s rate decision was difficult to predict. The RBA’s decision to keep the cash rate steady at 2% fell in line with market expectations.

But speculation over their future policymaking is causing confusion across the markets.

Some economists believe a rate cut will take effect this year. Others believe we’ll see another rate cut, but not until next year. And then there are those who say the days of rate cutting are over. Who’s right? Don’t ask the markets, because they’ll give you three different answers.

It doesn’t help that the RBA gave nothing away in their official statement. They trotted out the usual lip service to keep the markets guessing.

They announced they’ll make any future decision based on the economic climate. It’s the stock standard answer given every time they hold steady. But it’s also an admission of the uncertainty facing the economy.

The RBA likes to think it can surprise the markets through their policymaking. If they could just catch us off guard, the markets might react. But they can’t. And they haven’t been able to for months.

No rate cut this year has worked as planned because the economic prospects are floundering. The markets simply aren’t buying the idea that rates can fix our problems.

Sadly, economic conditions are only going to get worse in the second half of the year.

Markets are changing their tune on interest rates

When the RBA last cut rates in May, the likelihood of another cut seemed a distant prospect. The prevailing wisdom was that it would keep rates on hold until 2016.

But then things started to take a turn for the worse.

Global markets started to rock. From Greece to China, investors began panicking about the future of the global economy.

Closer to home, falling commodity prices have long dampened domestic growth prospects.

That left the RBA relying on a rate rise coming from the US. A few months ago, it seemed possible that the Fed would hike rates later this year.

The chances of that happening have now all but receded. There’s far too much lacklustre economic data coming out of the US to suggest a rate rise. The likelihood is that US rates will remain unmoved until late 2016.

That’s why we’re now seeing the narrative changing. Economists are taking on a more bearish tone in their outlook on rates.

They’re now penning a 100% chance of rates falling to 1.75% by April. They’ve also raised the likelihood of a December rate cut to 88%.

This is a significant backflip compared with earlier predictions. This time last month they gave a 68% chance for a rate cut taking place before December.

The next rate cut in November?

Andrew Ticehurst has a knack for guessing the RBA’s motives. He’s the interest rate analyst at Nomura, a financial holding company. Ticehurst is the only economist to correctly predict every single rate decision this year.

That makes his prediction for a November rate cut rather telling. He explains:

The big picture backdrop is that we haven’t experienced a recession in 25 years. Australia has lost competitiveness. We’ve fired some policy bullets and we’ve used up a bit of our luck.

‘Against that backdrop, the economy’s increasingly being hit by a couple of more cyclical headwinds. One is fiscal consolidation, both at the Federal and state level. The other is the mining unwind, which is being given added impetus by declining commodity prices, poor business sentiment and no expectation that non-mining investment is going to be able to take up any of the slack’.

The root of this problem — mining — will continue to drag on the economy. The reasons for this are twofold.

One is that the effects of China’s slowdown will continue to drag on demand.

The other is that oversupply of iron ore will exert further pressure on prices. So a November rate cut is both logical and timely.

Falling national incomes will only speed up the RBA’s decision to cut rates again.

Paul Dales, the chief economist at Capital Economics, says that falling national income tends to have a lagging effect. He says that the outcome of this will only hit us in the second half of this year. Dales explains:

Since it takes time for falls in national income to influence investment and decisions, we suspect that the size of the true hit to the economy from the collapse in commodity prices will only become clear in the second half of the year. [And] a further weakening in the dollar won’t be enough to cushion the blow.

The resulting slowdown in GDP growth will be more marked that the RBA expects. The ensuing extra downward pressure on the underlying inflation will force the bank to cut interest rates below 2%’.

That would explain why first quarter GDP growth of 0.9% was so positive. The effects of the mining bust simply haven’t caught up with us yet.

But when they do, we can expect to the RBA to cut rates by another 0.25%. However, even this is not likely to be effective in the long run.

Making life easier for exporters may not solve the underlying problems. Cheaper exports could easily fail to offset the expected drop in commodity prices. That would defeat the purpose of cutting interest rates in the first place.

It also wouldn’t help non-mining investments pick up. Business spending will remain flat as long as the economic outlook looks poor.

And that’s before we even address the major problem with company hurdle rates. Businesses expect a certain rate of return when making investment choices. For many companies, this hurdle rate sits above 10%. But lower interest haven’t translated into lower hurdle rates.

So why does the RBA think rate cuts will result in increased business spending?

The importance of hurdle rates to business decision making adds to the pressures on the economy. Declining mining revenues and slack non-mining business spending don’t bode well for the future.

Unfortunately, that suggests a sustained period of gradual decline for the Australian economy.

This is something The Daily Reckoning’s Greg Canavan has been warning us about for months. As one of Australia’s leading investment analysts, Greg says we’re sleepwalking into a recession.

In a free report, ‘Australian Recession 2015: Unavoidable’, Greg reveals why we face a recession in 2015. He’ll show you why our debt levels are so out of control and he’ll prove to you why the RBA realise the recession is coming.

Download your copy today and Greg will show you what you can do to protect your wealth from the fallout of the recession. To find out how to download his free report right now, click here.

Mat Spasic,

Contributor, The Daily Reckoning

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