This man should cut interest rates next week
It’s not an easy job, being the Governor of the Reserve Bank.
Glenn Stevens may have the benefit of hundreds of boffins feeding him historical data about the performance of the economy. But at the end of the day, no-one can see into the future. Interest rates are set in the Governor’s gut and those of his eight fellow board members.
And my gut’s telling me they should cut next week. There have been three important developments since the board last met. First, commodity prices remain off their highs, boding ill for investment and jobs in the previously red-hot mining industry. In his last statement, Stevens observed commodity prices had “fallen sharply in recent weeks”. Indeed, the price of Australia’s biggest export, iron ore, had tumbled to around $US86 a tonne.
It has since recovered to around $US104 per tonne, but remains well below the $US140 levels of the start of the year. Meanwhile, the price of Australia’s other major export, thermal coal, is also languishing below $US90 a tonne, down from $US110 earlier in the year.
Recession in Europe and anaemic growth in the United States means lower demand for Chinese exports; which in turn means lower Chinese demand for the major input to their steel making process – iron ore. But in the face of this contraction in external demand, China’s options for stimulating internal growth - through another stimulus package – are more limited than during the global financial crisis.
Of the 4 trillion yuan of stimulus spending back then, only 1 trillion was funded directly from the central government’s budget, with nearly 3 trillion yuan coming from local governments who in turn borrowed the money from commercial banks. This backlog of debt means there is less room for rapid stimulus. Throw into the mix a delicate leadership change-over in the Chinese Communist Party and slowing in Chinese growth looks inevitable.
Lower commodity prices have dampened activity and jobs growth in the fast growing part of the Australian economy.
Meanwhile, the Australian dollar remains high, dampening activity in the already cool parts of the economy, like tourism and manufacturing. The total result is a general cooling in economic activity, paving the way for lower interest rates.
The Australian dollar is the second major reason why the bank can cut interest rates next week. Usually, you’d expect the dollar to fall with commodity prices. But the Australian dollar has remained stubbornly high. When the Reserve board last met, the dollar was falling back towards $US1.02. But the US government’s decision to stimulate growth in that economy by printing money has put downward pressure on the US greenback pushing the Australian dollar back up to around $US1.04.
The perception of Australia as a relative “safehaven” for investment has seen demand for dollar-denominated assets like Australian government bonds soar.
A higher Australian dollar makes it easier for the Reserve to cut interest rate cuts in two ways; first, by exerting downward pressure on inflation (by making imports cheaper) and second, by dampening growth by Australian non-resource exporters and firms competing against cheap imports.
The high Aussie dollar is a foot on the throat of both inflation and growth, allowing the Reserve Bank to ease up a little on interest rates.
Finally, the Reserve Bank will take into account planned cuts to government spending at both state and federal level, and the impact this will have on reducing demand in the economy.
The Treasurer, Wayne Swan, has confirmed the government will cut spending to achieve its budget surplus in 2012-13. Some have criticised this as “pro-cyclical” fiscal policy – that is, cutting spending into an economic downturn.
Much depends on the size of the required cuts. Out of economic production worth $1.4 trillion a year, government cuts of $5 billion a year would remove just 0.3 or 0.4 percentage points from growth, which is manageable. Cuts of $20 billion a year would lop off a massive 1.4 per cent from growth. But spending cuts of such magnitude are not yet required.
With economic growth still at around trend, getting the budget back into surplus is the prudent thing to do. If the GFC taught us anything, it’s that governments are pretty bad at balancing the books.
If the government can do so now without sacrificing worthy policies, let them.
State governments too have caught the cutting bug, merrily slashing into front line service jobs. This helps to restore balance sheets, but results in higher joblessness.
Fortunately, there is a solution: lower interest rates.
When the dollar is already too high, a better policy mix is to have tighter budget settings and looser monetary policy. Lower interest rates would ease upward pressure on the currency and give relief to trade exposed parts of the economy.
And if the political bickering over government debt and surpluses shows anything, it’s that the job of managing short term demand in the economy is best left in the hands of an independent, and altogether less hysterical, Reserve Bank.
The only real thing arguing against a cut next month is the fact that unemployment remains historically low, leaving the door open for higher wage demands which fuel inflation. It would be unusual for the Reserve to cut interest rates at a time when the jobless rate was steady, or, indeed, falling a bit.
But these are unusual times. The pace of jobs growth has in fact slowed markedly, the low jobless rate made possibly only because of a sharp drop in the number of people looking for work.
On balance, the prudent course would appear to be a modest 0.25 percentage point cut to the cash rate when the board meets next Tuesday.
Of course, it’s anyone’s guess as to how much the big banks would actually pass on.
Twitter: @Jess_Irvine Email: email@example.com
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