The Reserve Bank of Australia has something of a problem on its hands. It’s not the fact that the economy has no pulse to speak of. Nor is it the effects of the ongoing strife consuming global markets. These are both problematic, to be sure. But they’re not things the RBA can control, and least not directly.
What the RBA can control though is Australia’s monetary policy. If you’re keeping an eye on the interest rates, you’ll want to know where they’re heading.
The RBA prefers to maintain rates at the current low of 2%. The markets appear perfectly happy to buy into the bank’s rhetoric. But try as it might to delay the inevitable, rate cutting is back on the RBA’s agenda. Here’s why.
Mixed international rate policy foreshadows RBA cuts
Last night, China’s central bank moved to lower interest rates by 0.25% to 4.6%. It came on the back of aggressive currency devaluation over the last few weeks.
Across the Pacific, the US Federal Reserve looks increasingly as if it’ll keep rates on hold in September. It comes after months of market speculation indicating the Fed would hike rates.
The effect of these decisions leaves the RBA in a difficult, if entirely predictable, position. Why? It’s because neither of these decisions work in the favour of the Aussie dollar.
On the one hand, the yuan’s devaluation, alongside the rate cuts, push up the Aussie dollar. It certainly won’t help it trend towards $0.70 against the greenback. And the Fed’s likely interest rate delay won’t help the dollar either. Rising interest rates would push the greenback up, lowering the Aussie. Without that, the RBA can’t rely on the US to make Aussie exports more competitive.
Without these external factors to support exports, the RBA has no choice but to retaliate.
Look at Australia’s balance of trade (BOT) for one. The BOT measures the difference between exports and imports. A negative BOT means we’re importing more than we export. Ideally, every nation would maintain a positive trade of balance. In reality, developed economies like Australia sustain manageable deficits.
Between 2008 and 2012, the country had a positive BOT across most months. That is, export revenues exceeded import expenses. This was the period when commodity prices peaked, buttressing Australia from the global financial crisis.
More importantly, since 2012, we’ve only had three months in which the BOT was in surplus. That in itself isn’t a cause for concern. As mentioned, developed economies are comfortable with negative BOT’s. But what’s worrying for Australia is that the BOT deficit has risen sharply in recent months.
The last quarter, between April and June, was the worst stretch we’ve seen in over three years. Here are the figures for the last three months, starting from April: $4.15 billion; $2.677 billion; $2.99 billion. Prior to that, we only had one month, out of the last 18, where the deficit rose above $2 billion.
At the same time, Australia’s terms of trade (TOT) is worsening. Unlike the BOT, it refers to the price of exports in terms of imports. In other words, you can look at this as the amount of imports we can buy for every unit of exported goods.
Worryingly, the TOT fell by 2.9% in the first quarter of 2015. In the last year, the figure has slumped by 11.4%.
As a nation, we’re importing far in excess of what we export. And, as the TOT suggests, our exports make us less than they used to. It means that we can’t rely on exports to keep the economy as stable as it was during the mining boom.
Predicting the RBA’s timeframe for rate cuts
I suggested in the title that the RBA would cut rates by November. Why November though?
The timeline itself isn’t altogether important. It could be October, it could be December. What’s important is that the RBA will cut rates — and soon.
But even the markets agree that November looks to be a good bet at this stage.
Interest rate swap markets show a 76% likelihood of a 0.25% rate cut by November. That measure was up from 64% last week, before the $60 billion loss on the ASX.
Others, however, disagree with this timeline.
Capital Economics, a UK-based analyst, doesn’t think Monday’s ASX rout will make much of a difference. It says that the stock market tumble isn’t large enough to affect the wider economy. And it thinks it won’t lead to slowing consumer demand or business confidence.
Let’s address each of those briefly, starting with consumer confidence.
According to Roy Morgan research, consumer confidence was unchanged this month. At a reading of 113.0 on its index, it was in line with the long-term average.
The research shows that Aussie households are concerned about the five-year economic outlook. But they’re less worried about the year ahead.
So is Capital Economics right? Well, not quite. They might be right in that consumer confidence is holding steady. But the same can’t be said of business sentiment.
Data from National Australia Bank suggests business confidence fell from 10 to six points during July. In NAB’s assessment, business confidence is trending below the long-term average.
Businesses aren’t spending because the expected return on investment is below par. Businesses are less inclined to spend when potential returns are so weak.
Total spending across the economy fell by 3.4% in the past year. Industries are holding back because the conditions for doing business are deteriorating. And it’s not just businesses cutting back on spending.
If business confidence remains sluggish, then consumer confidence won’t be far behind. Lacklustre business spending has only recently started ramping up a notch. If they’re not spending, then it’s hard to see where job and wage growth will come from in the long run. Without that, you can only stretch consumers for so long.
From this perspective, the outlook for the real economy isn’t as upbeat as Capital Economics make out. If business spending doesn’t pick up, then the economy will require another dose of monetary easing sooner or later.
RBA governor calls for major fiscal reforms
RBA chief Glenn Stevens is hesitant to cut rates because he knows it’s a case of diminishing returns. Every rate cut brings less benefit for the real economy, serving only to prop up asset bubbles.
That’s why he wants the government to focus on economic and tax reform to boost growth. Here’s what he had to say at the recent National Reform Summit:
‘The fiscal policy debate, usually framed as ‘when will we get back to surplus?’, is actually about how do we get more growth?
‘Other discussions, so often framed as about ‘fairness’ — that is income distribution — might be better framed as how do we grow the pie?
‘Growth rates have mostly started with a ‘2’ for a while now — despite the lowest interest rates in our lifetimes.
‘A key question worth asking is how do we generate more growth? Not temporary, flash-in-the-pan growth, but sustainable growth. The kind of growth we want won’t be delivered just by central bank adjustments to interest rates or short term fiscal initiatives that bring forward demand from next year, only to have to give it back then’.
Stevens suggests this could involve reforming tax and labour markets. A mix of these may create the right kind of mix to increase productivity.
Of course, he’s correct in identifying fiscal policy as a key to growth. By increasing growth, other issues like equality fix themselves. That growth isn’t coming from lower interest rates. In that respect it’s up to the government to formulate real plans for growth.
But Mr Stevens overplayed his hand a little too. How?
It’s rich of the RBA governor to question 2% growth rates in the current climate of low interest rates. More credit (or debt) floating around in the system doesn’t equate to growth. Mr Stevens should be fully aware of that.
In fact, it creates the kind of flash-in-the-pan growth that he wishes to avoid. As Stevens puts it, there’s no point to adjusting interest rates this year if it’s only going to bring demand forward a year.
And yet, this doesn’t stop the RBA from doing exactly that.
Reading his words you might think that the days of rate cutting at the Reserve Bank are over. They’re not — how can they be?
The RBA has known that the mining bust would produce the kind of slowdown we’re seeing. Yet that hasn’t stopped it from lowering rates to a record low of 2%.
Achieving growth will require fiscal (government) policy for a change. But it doesn’t mean that the RBA will sit idle. It can’t. Why? It’s simple.
The US Federal Reserve isn’t lifting rates next month, that much is clear. And China’s currency devaluation, and loosening monetary policy, dictates the RBA’s next move. It puts the onus back on the RBA to make Aussie exports more competitive. The Abbott government can’t do that — only the RBA can.
In order to push the Aussie dollar down, and lift exports, the RBA will have to lower rates again.
With both the balance of trade and terms of trade worsening, the pressure to cut again is rising. November seems a good as time as any to do just that.
Contributor, The Daily Reckoning
PS: Australia is set for a challenging second half to 2015. The RBA will be forced to cut rates again to increase the competitiveness of our exports. They’ll have no choice as GDP growth is on course to enter negative territory over the next six months. But will the rate cuts help us avoid recession?
According to The Daily Reckoning’s Greg Canavan, nothing will stop a downturn. As one of Australia’s leading investment analysts, Greg warns that the Aussie economy is sleepwalking into a recession.
In a free report, ‘Australian Recession 2015: Unavoidable’, Greg reveals why economic growth is going to fall sharply over the next five months.
Falling mining revenues, and higher trade deficits, are already taking their toll on the economy. Government revenues are down, household debt is up, and business spending is falling too. It’s a grim outlook, and one which could shock the economy to the core.
But there are actions you can take right now to lessen the blows of the recession.
Download your free copy today to learn how to protect your wealth from the fallout of the crash. To find out how to download his free report right now, click here.