Lowe pleads for government support as RBA running out of ammunition.

The RBA has done a complete 180 in just four months, from a tightening bias in February to passing the first of two consecutive cash rate cuts in June.
The RBA’s diminishing effectiveness means they are not expecting a full economic recovery until at least 2021.
RBA Governor Lowe is therefore doing everything he can to encourage further fiscal stimulus and structural reform from the government to more quickly absorb the economy’s spare capacity.

Back in February, the Governor of the RBA Philip Lowe said “the next move in interest rates is more likely to be up rather than down”. Since then, inflation has continued to disappoint on the downside and unemployment has crept up despite ongoing employment growth. The economy has continued to underperform with sluggish growth in household incomes and the cooling housing market depressing dwelling investment and tightening household budgets. Just as importantly too, the RBA reduced its estimate of the unemployment rate that is needed to drive up wage growth and inflation from 5 per cent to less than 4.5 per cent.

By June, this disappointing progress towards their own (suddenly more ambitious) targets forced the RBA’s hand. The cash rate was cut by 25 basis points – the first change in almost three years – then again in July to the current record low 1 per cent. The RBA is now waiting to see how these cuts – plus recent tax cuts, changes to lending regulations, the surprise election result and several international developments – play out across the economy before deciding upon further action.

What is particularly telling though is that the RBA is not forecasting wage growth, inflation and unemployment to reach target until at least 2021. Given how long they have already spent missing their targets, why wouldn’t the RBA try to accelerate this recovery?

Because the RBA knows it is running out of ammunition. It simply can’t (or won’t) accelerate the recovery any faster than this. At this point their ability to absorb the remaining slack in the economy is already diminishing. Governor Lowe himself, in his Opening Statement to the House of Representatives Standing Committee on Economics said “it is certainly true that, in the current environment … monetary policy is less effective than it used to be”.

At their current low levels, further cuts to interest rates are unlikely to be fully passed on to mortgage holders. Many lenders have already dropped the rates they pay on savers’ deposits (close) to zero so they won’t be able to offset many more cuts to their lending rates. Quantitative easing has been discussed as a means to reduce interest rates on longer term assets but generally only in response to a financial crisis or sudden exogenous shock to the macro-economy rather than merely a prolonged period of moderate sluggishness.

Another key channel through which a lowering of interest rates stimulates the economy – by pushing down the exchange rate and supporting exports – is also being undermined. Every major central bank in the world is expected to cut interest rates in the next six months. In addition to ourselves, the US, New Zealand, India and Thailand have already started – NZ by a market-shocking 0.5 per cent. The European Central Bank, the Bank of Japan, the People's Bank of China, the Bank of England and the Bank of Canada are expected to join soon. This means the exchange rate impact of any cuts to our own interest rates is being reversed by the same actions by other central banks – a phenomenon many are now dubbing a ‘currency war’. While cutting interest rates still has the benefit of shoring up access to affordable credit and boosting household disposable income even without the exchange rate channel, its stimulatory effect is diminished.

This is why for several years now Governor Lowe has been putting increasing pressure on government to undertake infrastructure investment and microeconomic reform. Perhaps the earlier experience of the US and EU at the zero lower bound made Governor Lowe wary of Australia reaching this point several years ago. In an attempt to not overstep his jurisdiction, Governor Lowe may have been very explicit in his recent testimony in saying that he wasn’t making “recommendations” to the government, just providing “options”. But the implication and urgency was clear. And now that we can virtually see the whites of the zero lower bound’s eyes, many other economists have come to the RBA’s aid in also calling for additional fiscal stimulus. This would push the economy back towards target faster – and arguably more effectively – than the RBA acting alone.

After all, actions by the RBA to change interest rates only affect economy-wide spending indirectly. Fiscal stimulus on the other hand is itself an injection of spending – especially during a downturn when it is less likely to crowd out the private sector. Strategic investments also have the added benefit of boosting the economy’s long term productivity. Nor is there a lack of infrastructure in which to invest or reforms to undertake. While there is already a substantial pipeline of State infrastructure work underway in NSW, Victoria and Queensland, capacity constraints are far less binding in States like WA, SA and NT. Moreover there are regional and smaller projects that can be fast-tracked all over the country that avoid these constraints.

Governor Lowe also advocated structural and productivity reforms including training and skills development.

“A strong, dynamic business sector is the best way of creating jobs and growing the overall economy. We do better if Australia is viewed as a great place to expand, invest, innovate and employ people.”

Reforms to property taxation could also help workers relocate to areas of superior employment prospects. Reforms to industrial relations could bolster business incentives to invest in their productive capacity and expand their workforces. Lowe also pointed to an increase in the Newstart Allowance as a more effective short term boost than the planned tax cut for higher incomes.

The Federal Budget situation is also looking increasingly positive. On the back of the six largest monthly trade surpluses on record – all occurring this year – thanks to the mining export boom, the Government’s promised 2019/20 surplus may even be delivered a year early. By both international and absolute standards, Australia’s Federal Budget is in a great position to provide additional fiscal stimulus to absorb the slack of a struggling economy.

It also isn’t often that government borrowing costs are so low. At this point in time, all governments in Australia can borrow for 10 years at an interest rate under 2 per cent – some much lower still. Rarely does a government have the opportunity to do so much good, so cheaply.

It is also worth pointing out that the current environment of record low borrowing costs is a global phenomenon. Across the advanced world, an ageing population is increasing the desire to save rather than invest. Economic anxiety and previous accumulation of debts are causing individuals to consolidate their budget positions. In China too, with its relatively weak social safety net, individuals have to save and depend on the government to invest. This trend towards saving is holding down global interest rates and means that even after Australia’s economy returns to trend, opportunities will still remain for us to borrow cheaply to finance valuable public and private investments. The world is crying out for investment opportunities and there are no shortage of them, especially for a willing government.

While the market is expecting two further interest rate cuts in the next year, the diminishing effectiveness of the RBA’s shrinking stockpile of ammunition and the Government’s strong budget position strengthens the case for additional fiscal support.