23 November 2019
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Between a rock and a hard place

David Bassanese
22 April 2015

By David Bassanese

The Reserve Bank is caught between a rock and a hard place.  It knows the economy continues to perform at a sub-par pace, and would like to lower interest rates further if it thought it could help. The problem is that cutting rates now appears a little like pushing on a string in terms of the support it can provide the real economy, while potentially adding fuel to the fire of financial speculation in the property and equity markets.

Unlike most other central banks around the world, the RBA remains concerned about balancing the needs for “financial stability” against that of supporting the real economy. The ongoing strength in Sydney property prices – and to a lesser degree the increasingly frenetic “search for yield” in the equity market – were the major reasons the RBA has baulked at cutting interest rates in the last few months.

Yet recent commentary from the Reserve Bank of Australia suggests it is still deeply worried about the local economic outlook. In a speech in New York, RBA Governor Glenn Stevens valiantly tried to talk the Australian dollar down again and suggested that the question of whether interest rates should be reduced further “has to be on the table”.

More worrying, the minutes of the April RBA policy meeting released this week seemed to contain another downgrade to the non-mining investment outlook – reflecting the recent weakness in non-residential building approvals and liaison reports from the corporate sector. Specifically, the minutes noted “forward-looking indicators (such as the ABS capital expenditure survey and non-residential building approvals) as well as liaison suggested that [non-mining investment] was likely to remain subdued, and could even decline, over the next year or so.” (my italics added).

That’s a far cry from the comments in the February Statement on Monetary Policy which suggested “the expected recovery in non-mining investment has been pushed out to later in 2015.”  The RBA downgraded its growth outlook back in February, largely due to this downgrade to the non-mining business investment outlook, which in turn justified the decision to cut interest rates that month. But it was still counting on an upturn in non-mining investment later this year. Now it’s not so sure, suggesting the growth outlook could be revised down again in the May Statement on Monetary Policy due out a few days after the May Board meeting.

If today’s consumer price inflation report is benign – as it should be given still soft demand and weak wages growth – that it turn suggests the RBA may well decide to cut interest rates again at the next policy meeting. That’s despite the fact employment growth surprised on the high side last month, and the latest National Australia Bank business survey suggested corporate sentiment has lifted a touch.

Whether lower interest rates help the economy remains to be seen. The RBA notes household debt is already high and consumers are not responding to lower interest rates in the way they used to.  In a classic catch-22, that in turn is leaving corporate Australia very reticent about investing.

Of course, lower interest rates could encourage further upward pressure in house prices – especially in Sydney – not to mention drive high dividend yielding stocks even higher.

To a degree, this rise in asset prices should be welcome, as the “wealth effect” on consumer spending is part of the transmission mechanism whereby lower interest rates stimulate the economy.

But over reliance on rising asset prices presents risks that valuations could get overly stretched, presenting downside risks to economic growth and inflation as it increases the chances of a more abrupt asset price correction later. Price-to-earnings valuations in the equity market are already now at previous (pre-internet bubble) peaks, and prices increasingly reliant on low interest rates – or a speedy recovery in corporate earnings – to sustain current levels.

As for property, my valuation measures suggest Sydney house prices to household income are currently pushing past their peak levels in late 2003, though due to lower mortgage rates traditional measures of “mortgage affordability” remains near their decade average. This suggest that house price could well rise further in coming quarters before affordability becomes an issue given today’s low interest rates.

In view of the risk to asset prices, the RBA would prefer that a much lower $A came to the rescue to help breathe life into the economy. But given extreme policy stimulus elsewhere in the world, the $A risks remaining too high unless the RBA also joins the party and cuts rates. 

The RBA would also prefer that Canberra do more to boost the economy – especially through pro-competitive reforms that unleash productivity without costing the budget too much.  But again, that seems too much to ask given the current political divides.

It’s left to the RBA to do what it can. Should the CPI remain benign today – as I expect – the Bank should act again by lowering rates in May.

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