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.