RBA headed back to 3%

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The slowdown in global growth, combined with an ongoing decline in domestic profitability, seems sure to see the RBA guide their official rate back to 3% before the end of 2012.

This much has been fairly uncontroversial for the last month or so. What has been much more controversial has been when the RBA will get started. My best guess is that the RBA will get started in October – that is tomorrow. My experience is that the Bank gets started right away when most everyone agrees that they will have some work to do in coming months.

Some commentators have pointed to the recent improvement in the domestic interest rate sensitive sectors and argued that the RBA should save their ammo. I disagree. This rate cut is something different.

Unlike the prior 125bps of cuts, this will be the first rate cut that is aimed at the slowing mining sector. Through family, I have heard of six coal mine closures since the RBA’s September meeting. I asked about headcount, and was told that ‘there are layoffs happening everywhere’.

So it seems that we have reached a new stage in the current economic cycle. We are moving to stage three of the boom – a stage that’s likely to be characterised by rising exports, falling prices, disappointing taxation revenues and rising unemployment.

I do not buy into the argument that the urgency for rate cuts has eased now as a result of spot Iron Ore prices bouncing ~20/t to ~105/t. The price may have bounced, but the animal spirits that boosted mining investment over the prior three years have died.

The mining cost of capital is likely to remain higher for an extended period — bankers will stay more cautious, and their equity cost of capital will remain a little higher (to reflect the higher risk). This is why investment projects are going to continue to be delayed and cancelled.

Mining investment as a share of GDP surely will rise a little further before it peaks, but it’s likely to decline pretty quickly from ~8% of GDP to ~4% of GDP (4% is around prior cyclical peaks). Sure, there is a pipeline, and there may be more work in it, but I cannot see another ~200bn bulge of projects to replace the bulge that will finish over the next couple of years.

Exports will rise and this will hold up GDP to some extent, but 1bn of exports employs fewer people than 1bn of investment. Additionally, the weakness in tax revenues means that the government sector is likely to be cutting jobs just as the mining sector is reducing employment.

To maintain full employment we will need faster demand growth from the non-mining private sector. The RBA can boost the incentive for both investment or consumption by lowering their policy rate.

While it may not succeed in lowering the AUD by much, a declining cash rate should offset the higher AUD. The high AUD is lowering the return on capital in the tradable sector, and depressing investment. In the context of falling export prices, the restraining force has now spread to the mining sector.

By lowering their policy rate, the RBA can boost the incentive to invest in these sectors. They can and should do so. I think they will take the first step, to 3.25%, at their 2 October meeting.

I doubt the major banks will pass this along in full to mortgage-holders. While the cost of their wholesale debt is now falling (as the massive credit rally means that their new debt is cheaper than the debt that’s maturing) the ongoing and intense competition for deposits continues to erode margins.

Depending on Q3 CPI, it seems most likely that we’ll see a follow up 25bps cut in November — which is likely to see your mortgage rate 35bps to 40bps lower by Christmas. Hopefully this will support spending and employment over the holidays.

Could they go even lower? Yes, and I think that they will. It is hard to see Australia avoiding recession as the mining boom ends. In our last recession, the cash rate fell by ~12ppts. It seems likely that the cash rate will have a 1-handle when we have our next recession.


  1. The ‘saving ammo’ argument has to be one of the most silly ever invoked for putting off monetary easing – by supposedly saving ammo, the central bank is impliedly saying that it is comfortable with declining growth and employment; this means that it eventually needs to cut by more to get agents to respond than if it had gone earlier. The RBA has been behind the curve since at least August last year. It seems determined to flirt with recession even though inflation is well contained. I think they must have been stung by criticism that they allowed inflation to run too high in 2006-08, so now they want to make up for it.

    1. I think there is much truth in your hypothesis – they know they got lucky in 2008. If it were not for the GFC they would have had to induce recession to get inflation back below 3%yoy. They cannot depend on such luck once again.

      As for the saving your ammo argument – i don’t think any central banker believes in it … It’s just a throw away line that is said by those that don’t get it. You can use it as an indicator of those who know what they are talking about, and those that do not.

      1. Bills market pricing in reduced chance of a cut this morning. I think if they don’t cut today, it will be because of the effect of QE3 on (1) US Sept ISM PMI (esp new orders) and (2) Oz house prices (the boost in the RP Data numbers since mid-Sept looks like an immediate reaction to QE3).

        1. you really shouldn’t use the bills. Use the IB futures, you can see delayed prices here: http://www.asx.com.au/sfe/futures_summary.htm

          You need only adjust for the day-count (unlike bills where you have day count issues as well as bank credit). In the present case we have had two days at 3.5% and 29 days at x, so the price (last traded at 96.65) implies about a 65% chance of a cut. That’s moved 3bps (or -10ppts from ~75%).

      2. Ah – thanks! That was the source/number I was looking at, but I had no idea about the day count adjustment.

  2. – If we get rates down to a 1 handle, then by when in your view?
    – Where will the AUD be if that happens?
    – Can we get rates that low and still maintain our net foreign liabilities or we risk a capital flight from Australia? Were rates that low ever before?
    – In your opinion, is it a worrying sign that rates are peaking at lower levels in each cycle or it does not really matter?
    – What is the probability that inflation will prevent RBA from cutting rates much more?
    thank you

    1. 1/ my current guess is that we will have a recession in the next two years – i think we will have ultra-low rates during the following two years — so i would guess 2015. the thing that would prevent this is a major global inflation.

      2/ i know i cannot forecast this, so i have assumed that it’s broadly flat. We need it lower but the medium term fundamentals keep pushing it up. long term valuation depends on foreign and domestic inflation risks — which includes how bad foreign fiscal matters have become. If we are still the only major economy that is conducting conventional monetary policy and have a somewhat normal deficit, the AUD could well be higher.

      3/ as far as i know, official rates have never ever been below 2%. It is an open question as to if we will run into any limits to our current account if we have very low rates, but in the context of global QE and massive ongoing deficits, i suspect official bond inflows will remain strong. We are actually a high investment nation — not a low saving nation — so if I am right about it being an investment led slump, then i am not sure that the capital account will be a problem.

      4/ i think it’s an enormous worry that rates peak lower each cycle. I think Schumpeter (along with some less worthy economists) had this as a central part of one of his theories — any HET experts, please comment. In particular, lower rates increases the probability that we move into experimental / quantitative policy — which really amounts to the taxpayer taking a lot of risk. I think in the medium term QE increases the probability that central banks lose their independence. I firmly believe that’s going to end badly — politicians aren’t good at the long run.

      5/ i have spent most of the last 10yrs trying to forecast inflation, so i know that there is at least a 30% chance of inflation being a problem, even if i am right about the medium term demand outlook. Still, right now, i don’t see much inflation. As far as i can tell, labour markets are slack, and there has been a sufficient supply response in commodity markets to mean we’ve probably see the near term peak for commodity driven inflation.

      the tech boom and shale gas booms in the US could usher in a period of strong profits growth and low inflation once it’s done destroying their old industries. Some say that the great depression was partly structural — caused by the move from agricultural to manufacturing production. They argue that something similar is happening just now. I am not sure, but again i’ve been wrong enough to see that it’s a chance.

      i’d love to hear your thoughts on these questions :)

      1. I agree on every point… including known unknowns…

        I think a lot will depend on what the AUD does. A stubbornly high AUD will mean lower rates, but if the AUD starts falling significantly, I think we could even avoid a recession in that case. I know a lot of exporters that would spring back to life with a lower AUD. And the share market would rise significantly.

        Really, a recession would be we entering uncharted territory for a lot of people in Australia, and the worry is what that will mean after 20 years of continuous (credit) growth. Your mate Joye published an article over the weekend, where he reports that “It is pretty amazing that nearly 40% of all owner-occupied home loans are approved with LVRs greater than 80%. But what is more remarkable is that 17% of all home loans currently being approved have LVRs greater than 90%. I guess that’s okay when house prices are rising…” he’s right, but what happens if we are in a recession? When you lose your job and you can’t find a new one soon, lower rates do not help. And if you can’t sell your house because it is worth less than what you paid for, you are in big trouble.

        So, maybe, I know it’s crazy thinking, maybe, you DO need a recession every X years, a mild one that is. And maybe the time is right now. Maybe the RBA do want to engineer a mild recession right now, to avoid paying a higher price later on. Kind of a way to break the vortex of “rates peak lower each cycle until it blows up”. Better have a recession with rates at 3% than one with rates at 1%. Which brings me to the questions: was the US “great recession” avoidable at all (for instance keeping rates lower or lowering them sooner / faster) or unavoidable, meaning that any actions by the fed would only have delayed the outcome???

        1. As i see it, our problem is that there is very little incentive for additional investment just now. It is unremarked-upon that listed profits peaked in early 2011 and have been falling ever since. even in the national accounts, profits have fallen in six of the last eight quarters. The high AUD is a part of this, for sure — but there seem to me to be many problems.

          the boom has hidden many bad business models. I was in Perth last week, and they have lots of video stores and even a timezone video game parlor in Fremantle! The boom has protected that city from a decade of structural change — and the rest of Australia is not so far different.

          so while a lower AUD will help, i don’t think it’s going to change the fact that a lot of business models are simply defunct. If the boom means tighter budgets, it could well mean more structural change even if we have a much lower AUD. that could make things worse for a while.

          there are two things i have learnt about reality and theory in economics — and they really seem to be the same lesson. The first is that the synchronization of global business cycles is much closer than can be explained by trade flows. The second is that the fragility of the financial sector is much greater than any stress test ever reveals. Partly this is because when things go wrong, everything seems to go wrong — but partly it is just that there is so much connectedness that is hard to see until it is revealed in the bust.

          remember when Bernanke said that the Fed had done the sub-prime thing ten ways and that it was going to cost a maximum of 200bn and would not cause a recession? on the narrow question of sub-prime losses they weren’t too far wrong … but everything else went wrong!

          as for what we can really do about cycles … that’s a very deep question. i went into the crisis wondering if policy could work at all.

          Schumpeter’s argument was that innovation would die, and that this would drive the rate to 0 — basically a marxian argument cloaked in an institutional theory of innovation.

          A theory i like better is that we can only bring forward so much demand etc with lower rates. So low rates bring demand — and hence inflation — from the future to the present. The more inflation we bring forward now, the less we have later (unless we do something nuts like print and distribute cash). This is basically a ‘fiscal theory of the price level’ argument.

          i dislike de-leveraging as a narrative as i think it misses what really goes on — as it’s too broad and general. The way i see it, it’s not debt per se that hurts, it’s failed investments … regardless of if these are housing investments or business investments. When your investment doesn’t pay off, you have to change your behavior to fix the repayment problem. Someone consumes less than they were planning to — either the investor or the financier — as a result. It has to be the case.

          We can shift these lower consumption paths a little in time and in scale with lower rates, but there are real losses that must be taken. we can soften them a bit by boosting capital accumulation with lower rates — but there’s a limit to how much we can make this work without demand.

          it’s a story that needs more development, but i think you can see that i’m arguing that once the capital was misallocated into housing, it was inevitable that someone would have to consume less. perhaps something could have been done to regulate housing investment in 2003 – but then those who gained from the housing boom would have had to consume less in those years.

          but i think this housing bubble over-shot a long way, and we brought a lot of demand forward — it didn’t require such a big boom to beat the dot.com bust.

          I think the lesson of the crisis is that regulators don’t understand what banks do — mortgage lending is one of the the oldest and most regulated parts of retail banking. the lesson i take from this is that mortgage lending with LVRs above 80% should not be allowed.

          if you cannot save 20% you cannot afford to run and maintain a house — they frequently break and need costly repair. no one wants to live in a street where houses fall into disrepair. It’s not good for anyone …

      2. Again agree 100% :)

        “The way i see it, it’s not debt per se that hurts, it’s failed investments … regardless of if these are housing investments or business investments”

        Yep, and like you mentioned a few days ago: “Ever get the feeling that the role of policy is to put the bad investments back into the money? At times it seems that way…”

        Absolutely. However, since putting bad investments back into the money is impossible (you only delay the realization that the investments is bad, you do not actually make it a good investment), when there’s a significant amount of bad investments in the system you get lower and lower interest rate peaks, and I guess that is why it is a very worrying happening: every time you start rising rates the economy chokes under the weight of the still unrealized bad investments. That’s where I say that getting rid of some of the bad investments incrementally, now, by not lowering rates too soon, could actually be beneficial: it avoids new bad investments from accumulating over old ones that we haven’t yet paid for! It’s time for some weeding before the whole garden gets covered, adding fertilizer is not always the best way forward :)

  3. I think we can and have done a lot about cycles – namely, sound monetary policy. As a NGDP-targeting devotee, I’m not particularly worried about the supposed frailty of the financial system. As Sumner points out, the decline in US housing investment and house prices started in 2006, but there was no GFC or Great Recession until the Fed stuffed up in mid-2008 and nominal growth expectations fell through the floor. I don’t believe Australia;s lack of recession for 20 years puts us in any different a position – if the RBA keeps NGDP growing at trend, then a recession in real GDP should not cause a financial crisis amongst our banks. On the other hand, if we keep going the way we are, with 3% NGDP growth, a financial crisis is a possibility if recession hits.

    I’m interested in the idea that “we can only bring forward so much demand etc with lower rates.” I don’t agree. It only seems that way now because monetary policy is too tight worldwide. If the RBA said it wanted to return NGDP growth to trend of 5-6% and reduced the cash rate to 1% to that purpose, nominal spending and incomes would rise very quickly.

  4. Rajat, let’s say tomorrow the RBA lowers the cash rate to 1%. Yep, the economy peaks up fast, bad investments get a lifeline, etc. until the RBA starts rising rates again. But as soon as they get to 2% this time, those same bad investments start collapsing, plus some new ones, and RBA starts lowring rates towards 0%, etc, etc and monetary policy becomes more and more ineffective.

    I reckon instead of avoiding the boom-bust cycles, the goal should be to mitigate the cycles.
    Now, we have not had a recession for 20 years, so where’s the business cycle?
    A recession should not be seen as the “devil” IMO, but just a natural happening of the economic cycle. It’s only when you try to repress it, that it will come back and hit with vengeance later on.

    PS I am no economist, just visiting this blog because it helps me thinking straight for my hopefully-money-producing investments, including forex :)

    1. there is no professional society for economists — if you want in you are in…

      there is a body of thought that subscribes to the cold-shower theory of business cycles — basically the Austrians and some newer ‘the market is always right’ types. While i agree that problems have hangovers (and that their solutions may cause long term problems) i am fairly sure that it’s moral to try and soften the cycle using monetary policy — in that it probably leads to better outcomes over the cycle.

  5. Rajat, one more thing…
    As a NGDP targeting devotee, how do you reconcile NGDP targeting with “It is pretty amazing that nearly 40% of all owner-occupied home loans are approved with LVRs greater than 80%. But what is more remarkable is that 17% of all home loans currently being approved have LVRs greater than 90%. I guess that’s okay when house prices are rising…”
    I mean how does the NGDP targeting theory addresses and reconcile bad investments and bubbles that can burst? You can lower rates as much as you want, but how do you sanitize potential bad investment of massive proportions, should that happen?


    1. I saw Chris Joye make that comment as well. I’m not sure how different those percentages are from pre-2008 figures. But I don’t see anything intrinsically wrong with them – who didn’t want to borrow 90%+ for their first house? It’s only mortgage insurance that forces a lot of first-home buyers to get a 20% deposit. if you have a job and house prices don’t fall substantially in nominal terms, it’s not a problem (as in 2008-09). Whereas even a 60% LVR won’t help you if you lose your job and can’t make repayments. The reason the US had a financial crisis was not because of too many sub-prime loans – sub-prime was a relatively minor problem. It was the collapse in NGDP that made even prime loans go bad when people lost jobs. Anyway, I’m parroting Sumner again so you can get a better version of these ideas by looking at his blog.
      As for the fear about giving bad investments a lifeline, I don’t think we have over-invested in housing in Australia. Housing is a lot more value-adding than many other capital investments we have made (eg BER, desal, probably the NBN, etc).
      BTW, I don’t see investment being made or not based on the cash rate, like it’s some kind of hurdle rate. The cash rate helps steer the nominal economy. One doesn’t invest when the cash rate is cut to 1% because one’s investment is expected to earn a 2% return. One invests because the 1% cash rate promotes NGDP growth of 6%, which makes the investment worthwhile. Therefore, a rise in the cash rate to 2% doesn’t necessarily put the investment out of the money if NGDP continues to grow at its 5-6% trend rate.
      I agree with Ricardo that the cold shower theory of recessions doesn’t make sense for the very simple because even economies with frequent recessions don’t avoid financial and other excesses. In the 1920s in the US, for example, the NBER dated three recessions of over 12 months each within the decade prior to 1929 – fat lot of good it did them when NGDP collapsed!

      1. thanks, I think the difference between 90% LVR and 60% is that if you have to resell soon (e.g. you lost your regular income) and house prices have gone down, at 90% you are likely to have more debts than your assets are worth, not so at 60%. A big difference. At 60% you can sell your house, use that 20% of equity that is left, maybe rent waiting to get a job back. At 90% you have no way out.

        “BTW, I don’t see investment being made or not based on the cash rate, like it’s some kind of hurdle rate”

        Well, an example specific to housing, when rates are very low, an “interest only” 90% LVR mortgage (very popular with starting property investors) can be covered with just the rent income, and the property can be positively geared. So rates do make a HUGE difference on the feasibility of a property investment. The problem is obviously what happens when rates start rising again.

      2. On your first point, I think it goes without saying that if you lose your job, it’s good to have more savings rather than less. The implications for the banking system are more complex and go to the moral hazard of implicit guarantees etc.
        On the second point, yes, but rates should only rise when the economy is stronger and asset prices should also be higher. The investor who was dumb enough to invest without free cash flow may have to sell, but the bank should not make a loss.

      3. Well, “maybe” on both points :) The risks of not knowing how capital is allocated out there when monetary policy is accommodative are not trivial. Stimulating investments with lower rates has the side effect of potentially stimulating bad investments too. Any central bank should not only worry about NGDP, GDP, inflation or rates, but also about the “internals” of those numbers. And housing must be very high on their list.

  6. It’s all about managing the gentle deflation of the housing bubble. Everything else will look after itself, but significant house price falls will wipe out the entire Australian economy, mining boom or no mining boom.

    1. i am not 100% sure that’s the stage we are at just now. In US terms, it feels more like 2001 than 2007 to me. our banks are fully valued, and there’s good prospect that house prices will rise as the RBA cuts rates to offset the end of the mining investment boom.

      i guess that puts the RBA QE experiment at around 2020 — if you go for this sort of dating stuff (and i’m not sure that you should…)

      1. Yes, it feels a lot more like US 2001 rather than 2007…. but we do want avoid 2007 in Australia if at all possible, and now is the time to plan for that :)

      2. Agree it feels like 2001: high exchange rate, sector-specific boom, low nominal official rates. Lucky for us, the US has been through the QE experiment before us, so hopefully we will be better equipped if and when our time comes.

    2. Ralph, I agree with that. Housing has to be number one concern for the RBA, because if that goes wrong, everything else collapses. The best outcome would be a gentle deflation / flattish for the next decade, and I hope that’s what they are targeting.

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