6 Dec 2012

Who's Afraid Of Interest Rate Cuts?

By Ben Eltham
Interest rates are low and cash is cheap. Does this mean the economy is floundering? Ben Eltham looks at the Reserve Bank’s decision to cut interest rates to emergency levels
If you listen to Treasurer Wayne Swan, he'll tell you everything's fine with the economy. The watchword is "resilience", as Swan hails the country's world-beating economic performance.

"Yes, it is the case that there is patchiness in some sectors of the economy, not everybody is on easy street, but there is a lot to be proud of in these numbers," the Treasurer told journalists yesterday.

Going by the headline numbers, Swan is right. Growth may have slowed to around 0.5 per cent for the September quarter, but for the last year it was 3.1 per cent. Unemployment is still just above 5 per cent. That's a figure much of the northern hemisphere could only dream of.

The Reserve Bank doesn't seem quite so sure. It's just reduced interest rates to what it used to call "emergency levels" of only 3 per cent. Cash is as cheap as it has been for a generation. Given that inflation remains subdued, unemployment is still low, and the mining boom has yet to bust, some economists are wondering why it's cutting. Does the RBA know something we don't? Is the economy sicker than we think?

The Australian Financial Review's Christopher Joye can't see the reasoning. He argues that the RBA is punishing savers. "Rather than wait for reliable empirical proof on the state of the economy, the RBA has been gambling that it is ahead of the game based on its subjective forecasts and partial activity indicators," he wrote yesterday.

The Reserve Bank's Phillip Lowe gave a perceptive speech to the Australian Business Economists Annual Dinner last night in which he addressed these concerns. It's worth reading in full, for those interested, but the take-home message is that the Reserve Bank is cutting interest rates... because it can.

Lowe presented the chart below at his dinner speech. As you can see, prices are remarkably stable, and have been for some time. The mandate of the Reserve Bank is to keep employment as high as possible, while still keeping inflation under control. And inflation is under control.

Inflation in Australia over the past three decades. Source: Reserve Bank

Because inflation is so quiescent, the RBA has the latitude to move rates down in order to address structural issues in the Australian economy. And the number one problem right now is the Aussie dollar. Our high exchange rate is slowly destroying the competitiveness of much of our export sector, as well as industries that must compete with exports, like domestic manufacturers. Lowe explicitly acknowledged this in his speech, saying, "interest rates are lower than they otherwise would be to offset some of the effects of an uncomfortably high exchange rate."

But there's another reason the Reserve Bank can cut interest rates: austerity. Few have been prepared to say it, but Australia has already jumped over our own smaller version of the dreaded American "fiscal cliff".

The United States cliff is of course steeper and scarier than Australia's, but the analogy is not invalid, because Australia's fiscal priorities are also being warped by political expediency rather than economic common sense. The difference is that US lawmakers have not yet hurled themselves off the precipice, while in Australia the base jump has already begun.

Of course, the two nations' economic circumstances are vastly different. While the US is clawing its way out of the deepest recession in seventy years, Australia enjoys astonishingly benign economic fortunes. As a result the contractionary force of the government cutbacks here is not as severe; with the economy still growing, there are still some industries expanding rapidly and there are still jobs for retrenched public servants to go to.

Australian governments have been cutting back hard on public spending. The Commonwealth, for instance, is midway through the largest fiscal consolidation in modern history, with tens of billions of spending subtracted, and thousands of jobs cut. The states have been at it as well: most notably Queensland, where Campbell Newman's Liberal-National government recently brought down a horror budget that will see perhaps 14,000 public servants lose their jobs. Such a desperate drive to surplus is largely motivated by political point-scoring — a slower consolidation at both Commonwealth and state levels would be preferable for job prospects and growth.

The effect of government fiscal policy is sometimes derided by certain schools of economics, particularly of a libertarian bent, which argue that consumers adjust their expectations to government taxation and spending decisions, and that these therefore have little effect on the real economy. In Australia, these arguments have been used to attack the 2009 stimulus package, for instance.

That perspective has been ambushed by the reality of recent events in Europe, where ferocious government cost-cutting has led directly to recession, just as conventional macroeconomics predicted it would. It turns out the government spending cuts do hurt the economy, as even the International Monetary Fund now confirms.

We've been here before. In the United Kingdom, a newly-elected Conservative government embarked on a savage austerity drive. The result was a double-dip recession. The same looks to be happening in Queensland. Despite the strength of the Sunshine State's mining industry, the hit to growth from the cutbacks was enough to drive Queensland's state final demand into the negative. It's not rocket science. Lower government spending is indeed a shock to the economy; laid-off public servants really do spend less money.

What we're seeing in Australia, in other words, is an economy slowing in part because of a mild bout of austerity. That austerity means interest rate cuts are needed if the economy is to keep pace.

Indeed, you could argue, as economist Stephen Koukoulas has, that the rapid move to federal surplus has given the Reserve Bank the room it needs to lower interest rates. "In terms of public sector demand, the fiscal tightening now chomping away at economic activity is even more dramatic than appeared to be the case a couple of months ago," he wrote this week. Koukoulas would like to see interest rates move even lower, perhaps to 2.5 per cent.

Does it matter that interest rates are so low? Certainly, savers are feeling the pain. People depending on fixed income savings for their livelihoods, such as some self-funded retirees, are worse off with nominal interest rates at their current levels. On the other hand, home owners repaying mortgages are much better off. And because Australians have a lot of mortgage debt, the rate reductions have a significant impact, even if many people use the opportunity of lower rates to pay off more of their loans.

One acknowledged risk of cheap money is that it can ignite speculative bubbles in asset prices, especially property. Indeed, the Reserve Bank has been open about its hopes to assist the housing construction sector by lowering rates. But while a renewed property boom can never be discounted, there are no signs of one yet. Home prices remain subdued, and are even going backwards in Melbourne. Perhaps the real dynamic at play here is the fact that Australian house prices are already so elevated that first-home buyers simply can't afford to enter the market, and won't be able to until house prices deflate to more reasonable levels.

Perhaps we should really be asking: what are we actually worried about here? If interest rates really are too low, we'll find out in 2013 when inflation starts to pick up. I don't think it will, but even if it does, interest rates can always be raised again. In the meantime, lower interest rates should help many sectors of the economy that are currently struggling. Who's afraid of interest rate cuts? Not me.

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Posted Thursday, December 6, 2012 - 15:41

Whether interest rates go up, go down, or stay the same, I can safely predict one thing: the Opposition will ferociously attack the government for it. That's a sure bet.

Posted Friday, December 7, 2012 - 14:57

Interest rate cuts don't help the savers, be these prudent people, self-funded retirees, pensioners who supplement their age pension, etc.

They do help consumerism which is not good for the environment, and they help increase private debt if it's cheap to borrow.

They should help the manufacturing industry and anyone who borrows to invest and create assets, but the manufacturing industry is hampered by the high dollar more than by high interest rates. Business is also hampered by low productivity and high labour costs.

We need real reforms, deep reforms. Everyone just fiddles at the edges.

And the Opposition does not have an answer because they are too busy opposing.

Posted Friday, December 7, 2012 - 15:31

"The effect of government fiscal policy is sometimes derided by certain schools of economics, particularly of a libertarian bent, which argue that consumers adjust their expectations to government taxation and spending decisions, and that these therefore have little effect on the real economy."

This is Ricardian Equivalence. It is an assumption borne of lazy ideology with no empirical basis. It is also explicitly or implicitly assumed in all CONVENTIONAL macroeconomic models. It is one of the reasons why the Treasury modelled 4% GDP growth this financial year and a budget surplus despite the fiscal contraction you pointed out. It also explains why the IMF consistently overestimates GDP growth in the Eurozone in the face of austerity.

It is very much part of, and indeed dominates conventional economics.

Posted Friday, December 7, 2012 - 16:02

Marga - how did the economic left lose someone like you concerned as you seem to be with pensioners and the environment to monetarism?

Monetarism doesn't even pretend to give a stuff about either. Got its hands full with the emiseration of 99% of the population. And yes emiseration is probably an appropriate response to climate change, but probably a little too unnecessarily masochistic for most people's tastes.

Posted Sunday, December 9, 2012 - 09:38

Marga, this is the 1st time I find myself disagreeing with you.

So please explain how you came to these conclusions.

"Business is also hampered by low productivity and high labor costs."

Mining is the only Industry that pays high wages for obvious reasons but that is starting to come off, as the Industry that employs less people then Bunnings contracts.

There is no evidence that I have seen that supports your claim a Claim made by mostly small Businesses that are based on unsound Business Models, geographically badly placed or unsustainable in an economy with no real disposable incomes.
This is hardly the time where you spend money on Bizzare Hobbies, unless you got more dollars the sense. So all those small businesses that cater for the high disposable incomes tend to whinge through their Union Bodies, like the small business council.

So, facts pleeeeeese.

You can't have high consumption the retail sector, without higher and or fairer wages somewhere in the economy, unless you expect the people to borrow money into exsistance to finance the retail sector, but you know where borrowing takes the country. Hello America.

Now I don't see why I should have to borrow money into exsistance just some Ego Maniac can have a 400% mark up on a sandwich or a Cup of Coffee. I'll make my own and let them survive on the Dole, its cheaper. The Tax Purse as mentioned above employs a lot of people to support the Economy/Retail Economy at great expense which is not appriciated by the morrons who benefit, just so they can Income split to avoid Taxes and have their families on higher incomes then The Dole offers their Junior Ego Maniacs. Thats why Businesses now support higher Dole Payments because Businesses don't turn over enough to employ Junior on Higher rates of Pay as opposed to the Dole if he/she wasn't working for Mommy and Daddy. Unless your an Inbred you don't work for more then 4 hours a day in most small Retail Businesses.

The Post Office only Gurantees their casuals something ridiculous like 16 hours a week.

Posted Sunday, December 9, 2012 - 09:51

Ben Eltham, thank you for another great article.

Some will undoubtably find something to argue with, but its a discussion we need to have.

What does Economy mean to all Individuals and Bodies of any kind in Society and does the Government have the right to Govern on behalf of some while willfully ingnoring other sectors of the Economy/Society.

The ridiculous Health Insurance Industry having been a good case study, or the Super Industries.

I'm yet to figure out what the Benefits were and are of those Industries to society other then Profit taking for Senior Executives who treat them like Thiefdoms, talk about coruption in Manufactured Industries for the sole Purpose of creating Business opportunities for Ego's.

Posted Sunday, December 9, 2012 - 12:22

ok, I try to elaborate on this a bit more, in a general sense, as I have no access to facts and figures.

1. All my Australian life (quite a few decades by now) have I objected to the payment of penalty rates: penalty rates for overtime, penalty rates for weekend and public holiday work. Why should I be paid more for the same work and same level of productivity on a Sunday than I get on a Monday? I know the arguments behind that rationale, but to me they make no sense; I explain them away. However, these penalty rates add enormously to the cost of labour.
I grant differentiation for shift work. However, that should be expressed in working hours not extra money, i.e. a day shift = 8 hours, an evening shift = 6 hours, a night shift = 4 hours - or something like that. Night shift is notoriously hard to stomach anyway.

2. Increasing productivity is all about working smarter not working harder. It is about matching the right labour with the right capital, getting your administration, your strategies and tactics right, your SWOT right.
Australia could improve here.
I think the North-Europeans do a much better job there than Australians do, and so do some Asian countries.

3. The Australian legal system is an adversarial system, especially by industrial law. It is always labour (workforce through the unions) v. capital (management). Who wins the tug-of-war. Why not work together (in Germany union members sit on the boards) and acknowledge each others interdependence?
Salaries too should be expressed as total costs, not as they are now: namely the payout component to the recipient plus oncosts.
Oncosts can be enormous but often (not always) remain hidden in negotiations.

One example: a while ago the parliamentarians increased their remuneration by incorporating allowances into their salaries, telling the voters that it would not cost more since allowances would be abolished to the amount that salaries would be increased.
Not so. Apart from the fact that I do not really believe that allowances will all be abolished, this strategy move increased superannuation entitlements considerably. I fired off letters to the Age and AFR (both published them). I also found out that quite a few people had not thought of this oncost component.

I stop here as I do not wish to compete for the longest-post-on-NM award. I much prefer the KISS principle

Posted Sunday, December 9, 2012 - 19:44

Thank you Marga, some very valid points you make.

But I would have thought that most EBA's would have done away with most of the penalty's. Some jobs are not suitable for Sunday shifts or even Saturday. Horses for Courses.

I agree also that the Germans have a far better system, they are more Egalitarian then us. We only talk the talk, we don't walk the walk.
We have our good points, but most people I talk to, one of my mates who took is Australian wife back to Germany so that his child could have a better education and also because he prefered the life style, reckoned Germany was more advances where it counted for him personaly.

But like he said, having an Australian wife and child gives him the best of both worlds and he fully intends to go back and forth every few years so as not to deny his daughter her Australian Culture and family. He is a very smart Guy, very likeable.

Like the Yanks we are all Hype, with a secret little class system that no one acknowledges, but its there and always has been.

Posted Sunday, December 9, 2012 - 19:49

Marga, one more point.

The Germans also had Bader Mainhoff who forced a lot of changes on Germany as a Nation, which turned out to be quite a good thing in the end.