The RBA is running out of ammunition and the government must pick up the slack.

The RBA has cut interest rates to a record low with further cuts likely this year.
This was a response to their own internal recalculation of the NAIRU that showed us to be even further from full employment than previously thought.
Add to this the possibility of a sudden actual real-world shock, and monetary policy is dangerously close to the lower bound of its effectiveness.
Government needs to take the hint and use fiscal stimulus and reform before the RBA runs out of ammunition and before wage and inflation expectations make a proper recovery even harder.


The RBA has cut interest rates to a new record low of 1.25 per cent. This was not a response to a sudden new market development. Rather, the RBA has recalculated its estimate of the ‘non-accelerating inflation rate of unemployment’ or NAIRU – the rate of unemployment consistent with low and stable inflation.

Previously the RBA believed the NAIRU was 5.25 per cent and an unemployment rate around 5 per cent would result in stronger inflation and wage growth.

Now they estimate the NAIRU to be around 4.5 per cent and that an unemployment rate even lower than that may be necessary to lift inflation back to within their target range, and improve wage growth for Australian workers.

The RBA consequently cut interest rates in the face of this new understanding and it should help support the economy. This added relief for mortgage holders could result in greater discretionary spending (retail, services, etc.) and additional debt being taken on for things like furniture and vehicle purchases. It should also cause a weakening of the Australian dollar that will improve export profitability and potentially divert some import spending to the employment of any currently-idle domestic resources.

The housing industry should also benefit directly from this. The RBA’s interest rate cuts combined with APRA’s potential reduction in lending ‘buffers’ should make new home purchases available to people who previously couldn’t access it. Greater borrowing capacity (and willingness) will support the home building and renovations industry.

Perhaps just as importantly, this new stimulatory environment is here to stay for an extended period. As recently as December last year, the RBA was forecasting that the next interest rate move was more likely to be upwards than downwards. Now, just six months later, the RBA has cut interest rates and there are probably more cuts coming. Downside risks are likely to continue into 2020 and beyond.

Moreover, the RBA may run out of interest rate ammunition before having returned the economy to the path towards full employment. Without a sudden positive international development or more ambitious fiscal response, this sets the scene for a somewhat impotent RBA, a prolonged period of economic underperformance and a low interest rate environment continuing for the foreseeable future. The government’s own wage and inflation forecasts – upon which much of their budget is based – could also be in jeopardy.

While low interest rates are, on the face of it, good for the housing industry, if they are a response to ongoing weakness in the broader economy and therefore, limited demand for housing, even the housing industry won’t be smiling.

Add to this the possibility of a sudden actual real-world shock, and monetary policy is dangerously close to the lower bound of its effectiveness. Estimates suggest that once the RBA reaches a cash rate of 0.5 per cent, further cuts won’t be stimulatory because the transmission mechanism would have been exhausted. Even quantitative easing has had mixed results around the world and may not be the economic panacea we would need.

Government needs to take the hint and use fiscal stimulus before the RBA runs out of ammunition and before wage and inflation expectations make a proper recovery even harder. Incoming tax cuts will be of great help and there is scope to bring forward some of the government's smaller and simpler infrastructure projects for immediate commencement. Federal infrastructure investment levels in general could also be even more ambitious – with appropriate costing and consideration for potential projects.

There is also scope for microeconomic reforms that improve productivity and efficiency across the economy. The replacement of stamp duty with a broader based land tax – or consumption tax like the GST – would be particularly beneficial for the struggling housing industry:

• It would facilitate downsizing for retirees, making larger homes available for new younger families;
• It would facilitate a more mobile and flexible workforce with people able to more easily relocate where jobs are available;
• It would provide State governments with a more stable source of revenue than stamp duties that tend to dry up just as the economy is in need of stimulus;
• It would help alleviate the intergenerational inequality that can emerge when one generation is lucky enough to be invested in the property market before a record-breaking boom.

Government has no excuse to sit on its hands. There is no shortage of productive investments and reforms to undertake, especially with borrowing costs so low – and falling.

While the story of independent central banks has been one of success for the last quarter century, monetary policy is not without its limits. It was never intended to entirely bail out the government from its responsibility for macroeconomic management. The coming years will test the government’s willingness and ability to pick up the economic slack that has emerged.

The Holy Quintet

5 Factors to Rescue the Australian Economy

In quick succession, five factors have come together that could officially end Australia’s economic downturn – the election, property tax policy, tax cuts, APRA and the RBA.
But true to form – and despite the expert consensus – I think the RBA will wait to see how things play out.

The RBA meets today for its June Monetary Policy meeting and virtually everyone is predicting an interest rate cut.

Except me. Just as it has for the last 33 months, I think the RBA will hold fire.

Not because I don’t think they should cut – I think they should have cut six months ago. The Australian economy has been slowing since mid-2018. House prices have been declining since late 2017 so the risk of overheating the housing market with lower interest rates has gone. Credit is tight. Inflation has undershot the RBA’s target range for years. Wage growth has underwhelmed despite strong employment growth and low unemployment rates. GDP growth rates for the last two quarters (and leading indicators for the March 2019 quarter) have also disappointed.

So why wouldn’t the RBA cut interest rates? Because in quite quick succession, four other factors have come together that could officially end Australia’s economic downturn:

1. The election. There is always uncertainty surrounding a Federal election. Activity in the property industry tends to slow down around this period as investors and owner-occupiers wait it out to see if there are any drastic tax or legislative changes that could affect their purchase decisions. With the outcome of the election now settled, this uncertainty is now over.
2. Negative gearing and capital gains tax. This election was also more relevant to the property industry than any usual election. Labor’s planned changes to negative gearing and capital gains tax would have put further downward pressure on demand for housing, house prices and construction activity. At a time when confidence is shaky and there are concerns about the prospect of a hard landing for the property market, any further (even small) shock to the sector could trigger a crisis of confidence and a steep downward spiral for not just the property market but also the broader economy. That would mean many more people unemployed and slower (even backwards) wage growth for those that retain their jobs. With Labor’s defeat and the conservative incumbents retaining power, these specific concerns are now off the board.
3. Fiscal stimulus. During the Federal Budget in April, significant fiscal stimulus was announced by the government. This included $7.5 billion in tax cuts for 2019/20 and similar in 2020/21, plus $100 billion in infrastructure spending over the coming decade. A significant portion of these tax cuts will also be given to the middle and lower end of the income spectrum where they are most likely to be spent (e.g. retail, services) and boost economic activity. Recent estimates have put the positive economic impact of these tax cuts as equivalent to a 0.5 per cent interest rate cut by the RBA, around the same as the Rudd Government’s ‘cash splash’ during the GFC. This is a timely stimulus given weak recent economic growth, inflation and wages.
4. APRA also made an announcement last week that could officially end the credit squeeze. Until now, APRA has required that banks assess potential mortgage-holders against an interest rate of 7 per cent. To be even more conservative, banks adopted a 7.25 per cent assessment benchmark. This was tightening the supply of credit drastically. Now APRA has indicated it will remove its 7 per cent rule in favour of banks adding just 2.5 per cent to the going mortgage rate. This could bring the assessment rate down by a full percentage point and should loosen the supply of credit and foster greater activity in the housing sector. There will also potentially be fewer defaults on previous sales that are soon to seek finance on land or dwellings that have subsequently lost some of their value in the face of falling prices.

This is a fortuitous confluence of factors that may continue Australia’s run towards 30 years of continuous recession-free economic growth and help us truly earn the title of ‘the lucky country’.

The RBA could make it five – the ‘Holy Quintet’. But for now, I wager that ‘Philip the Patient’ will remain just that.

Philip Lowe indicated last week that the RBA will “consider the case for lower interest rates” in June – hardly conclusive but the market took this as his strongest indication yet and is now 100 per cent sure that the first change of interest rates since August 2016 almost three years ago is going to happen today. Market expectations of two interest rate cuts this year have been reinforced and even brought forward. If correct, this would bring RBA interest rates to a new record low of just 1 per cent. This added relief for mortgage holders could result in greater discretionary spending (retail, services, etc.) and additional debt being taken on for home, renovation, or vehicle purchases. It should also cause a weakening of the Australian dollar that will improve export profitability and potentially divert some import spending to the employment of any currently-idle domestic resources.

But given the above four factors, I think the RBA will wait to see how they play out first. Maybe they want to leave some interest rate ammunition in reserve in case of a significant new domestic or international shock (not a strategy with which I agree, but still). Maybe they want to avoid encouraging heavily-indebted households to take on more debt (unlikely to happen in current circumstances, in my opinion). Maybe they genuinely believe a cut isn’t necessary and/or won’t help (again, I disagree). Nevertheless, I hope their patience is vindicated.

A lot is riding on it.