Interest rate speculation pushed into overdrive.

Australia’s economic fundamentals are still strong.
But the local housing downturn, the global trade war, increasing international borrowing costs, a slowing EU, structural issues in China, and general instability all threaten to derail both global and local economic momentum.
The risks are asymmetric to the downside – the RBA should pre-empt them by dropping interest rates this year. The costs of not doing so are potentially much larger.

 

Death, taxes and cash rate speculation – these are universal constants. But in recent months, speculation about the direction of the Reserve Bank of Australia’s (RBA) cash rate have pushed this speculation into overdrive (at least amongst us economists).

The RBA – for many months now – has very clearly been signaling that its next cash rate move will likely be upwards. Many players in the industry agree, speculating some time in 2020 for the next rise.

There are good reasons for this upwards cash rate broadcasting.

Australia is continuing its approach towards 30 years of uninterrupted economic growth. Growth recently returned to trend following the mining and resources fallout, supported by strong home building activity and public infrastructure spending. The labour force continues to strengthen too, with unemployment back down to 5.0 per cent.

We are also being supported by a buoyant global economy. The US is experiencing one of its longest economic recoveries on record. China continues to generate economic growth rates beyond the dreams of any developed country. And advanced economies have driven strong global economic growth in recent years.

It is in spite of – or perhaps *because* of – this strong performance that there is increasing nervousness about the future. A number of prominent pundits have broken from the herd and begun canvassing the idea that the next move could actually be a cut. These concerns mainly surround two perceived risks – a global shock and a major local housing correction.

The IMF has just revised down its forecasts for global growth in the next couple of years; the trade war between the US and China (and perhaps the EU too) threatens to derail global momentum; recent negative economic data out of both the EU and China have raised concerns; and ongoing insular, nationalistic and anti-globalisation sentiments surrounding not just Trump’s America, but also Brexit, the Italian budget situation, recent French riots, and many other regions, threaten in the short term to shock the economic outlook, and over the longer term unwind decades of wealth generation, poverty reduction and international cooperation and stability.

Closer to home, Australia has its own ‘Moloch and Mammon’ on the horizon. Since their respective 2017 peaks, dwelling prices in Sydney have declined by 11.1 per cent to December 2018, and by 7.2 per cent in Melbourne. Nationally, prices are down by 5.2 per cent. The November housing finance figures showed that the number of loans by banks for the construction of a new home fell by 2 per cent in the month of November to be 9 per cent lower than the previous year. The change in the housing cycle had a direct impact on the flow of new residential building work entering the pipeline and creates a risk that the change in housing wealth may cause households to reduce consumption expenditure.

The continuing housing market downturn has thus far not resulted in a significant wealth effect on household consumption. The largest price declines have been at the top end of the price spectrum – households that are less sensitive to changes in wealth and therefore, less likely to significantly cut back on consumption. But this is not a forgone conclusion and while we have long been anticipating a housing downturn (five years of housing construction completed in just four years couldn’t be sustained indefinitely), and ongoing population growth will continue to absorb housing supply, there is still ongoing uncertainty about the downturn’s true length and depth.

Record household debt levels have not yet caused households to tighten their belts and there are few concerns from the RBA about debt serviceability with mortgage arrears remaining low. But wage growth has only just begun to tick upwards from is recent sluggishness and is definitely not guaranteed to continue that way. Combined with structural issues like ageing populations and low productivity growth, wage growth could continue to struggle, putting pressure of heavily-indebted household budgets and increasing their vulnerability to increasing borrowing costs.

Slower global growth will slow the pace of interest rate normalisation around the world but the combination of APRA’s tighter lending standards for investors and interest-only lending and the Royal Commission into the financial industry have acted to tighten local finance conditions not just for investors, but also owner-occupiers (even though APRA’s caps have since been removed). The time it takes to gain approval for a loan has blown out from around two weeks to over two months. And we saw just last week that NAB increased interest rates independently of the RBA and other commercial banks, citing these increasing costs of finance. When the impact of the findings from the Royal Commission become apparent, plus Labor’s proposed changes to negative gearing and capital gains tax, it could be the trigger to a steeper property market decline and the thus far-absent wealth effect on the broader economy.

Perhaps most important to Australia – as has been the case for the last 20 years – is the fate of China’s economy, our single greatest export market. There too, significant amounts of debt have been accumulating. China’s massive ‘pump-priming’ following the GFC averted a significant downturn. But it unfortunately also shifted huge amounts of resources away from potentially productive and innovative private sector uses back into government infrastructure and programs, unfortunately derailing their transition from an investment-led to a more sustainable consumption-led economy.

Recent slower economic growth and other worrying data out of our behemoth neighbor to the north poses the question – do they still have the will and the means to carry themselves through the next downturn? To be fair, people have been talking about Chinese imbalances and slowdowns for a couple of decades now, and China has continued to defy expectations. Even the GFC couldn’t knock them over. Policy makers and regulators have also been attempting to address some of these imbalances for a while now. But these predictions only need to be right once. And doesn’t the fact that these imbalances haven’t disappeared (and have actually got worse) add *more* weight to the argument for every year China keeps kicking the can down the road, not less?

Furthermore, the international trade war – even though escalation is still forecast to cost the global economy only in the low single digit percentages of GDP – could represent the trigger for some of China’s more significant imbalances to reveal themselves.

 

These are a lot of national and international factors that could turn against Australia in the near future. Hence the recent boom in RBA cash rate speculation.

Monetary policy is supposed to be proactive, not reactive. The US provides a good case study of this during the GFC. It was real-time feedback from financial institutions around the country rather than deterioration in official statistics that revealed the sudden liquidity emergency being faced and triggered the unprecedented response from Ben Bernanke and the Federal Reserve.

In Europe on the other hand, they did wait for longer and actually initially increased interest rates because they were more concerned about inflationary pressures than the financial crisis that had already begun. Consequently, the pain that followed was much greater than in the US.

Our own RBA Governor Philip Lowe – generally seen in the industry as a rather conservative figure – would arguably need a significant new development to occur to consider not just delaying any future increases, but actually dropping the cash rate from its current record low 1.5 per cent.

What then would need to happen for the RBA to reverse its long-broadcasted position that the next cash rate move will be upwards? A sudden deterioration in official economic indicators? Unemployment to jump up over 6 per cent? Inflation to fall below 1.5 per cent? Economic growth to turn negative? An influx of panic from their business liaison program?

There is a lot that could go wrong in the near future for Australia and the world.

Notwithstanding one (or more) of the above potential global shocks, I am only predicting a manageable slowdown in the Australian economy, rather than a drastic correction or recession. But I do think this will be a valid justification for the RBA to drop interest rates this year. They no longer have to concern themselves with overheating the property market. In fact, the combination of tighter credit conditions, the imminent impact of the Royal Commission’s findings and increasing global borrowing costs means it may be very irresponsible not to drop interest rates further. The risks are asymmetric – much larger to the downside than the upside. Why not drop rates?

The RBA may suffer a bit of embarrassment if they suddenly change their position. But policy makers need to be willing to consider rapid reversals of position if the worst should happen. By the time it shows up in the official data, it could be too late.