Who's Afraid Of Interest Rate Cuts?


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.

Ben Eltham is New Matilda's National Affairs Correspondent.