RBA should cut rates today

November 1, 2011

RBA and Interest Rates

The RBA should cut rates today because the Australian economy needs it. I’m not going to have two bob each way and say maybe they wont because I think they should – if I’m wrong I’m wrong and there wont be any hiding from it. But to reiterate I think they should cut today and then I think they should cut in February and then, with rates at 4.25% (which was the pre-GFC modern-day low) they should see how things pan out.

Readers know that we have been of the view that the Australian economy was not as strong as many thought for many months. Certainly since we started this blog in May and before that in other spaces. Key for us was the micro level data we look at a snapshot of which you can find each week summarised in our Data Vault .

 

Indeed we simply thought inflation was not the problem many said and that they were too fixated on that Phillips curve paper from the RBA 2010. Just have a look at the TD-MI monthly inflation gauge chart above. This is the most recent data released yesterday and clearly shows both headline, and crucially, underlying inflation falling. Australia is experiencing disinflation again – the globe is on the verge of deflation.

Rather noting the relationship between inflation an unemployment as one of the drivers we sought to understand where employment was headed not where it was.

Thus we focused, almost forensically, on the deterioration in the employment indicators and what they suggested for unemployment, employment and consequently household incomes. This deterioration you can see as the white line in the chart above – it is the NAB employment index and it has been followed down by both full-time employment and total employment growth. Note it has stabilised though so we’re not thinking Armageddon in the job market by any stretch of the imagination. this is one of the reasons we are 50 bps not the current 100 bps in market pricing.

Looking more broadly Australia is the envy of many countries. Our Government is not overburdened with debt nor is it running unsustainable fiscal balances. While a small cabal of Australian companies make up more than 90% of the ASX profits in general Australian corporate balance sheets are in good shape. This is not necessarily the case for Australian households which have materially increased their gearing over the past 15 years or so. as you can see in the chart below.

So households need to rebuild and repair their balance sheets. Readers know that we strongly believe that this Austerity Australian style is all about household retrenchment and de-levering and is structural rather than cyclical. The RBA DID NOT SHARE THIS VIEW until very recently. We know that because they told us they disagreed with us but Ric Battellino’s speech last week clearly showed they have changed their tune.

 After a 10–15 year period during which households increased their gearing and reduced their rate of saving, they have returned to a more conservative, and traditional, pattern of financial behaviour. Household credit growth has slowed to a rate in keeping with, or slightly below, the growth in household incomes;  the saving rate has increased to a level that is more normal based on history;  and household spending growth has slowed from a rate that substantially exceeded household income growth, to one that, over the past year, has been broadly in line with income growth. Within total consumer spending, there appears to have been a shift away from spending on goods in stores to spending on services, particularly services such as overseas travel, eating out and entertainment. As a result, retail sales have been particularly weak.

This adjustment in consumer behaviour has created a difficult trading environment for some businesses, coming as it has after a prolonged boom. But the adjustment in Australia has been benign compared with the adjustments in household finances and housing markets elsewhere in the world, and it has put household spending and financing on a more sustainable path. This will ultimately benefit the health of the economy.

This is important for the monetary policy outlook because they are no longer waiting for the dam that is holding back household spending to burst and pour forth a wave of spending across the economy. Rather, now they see the increase in saving as structural and an increase in incomes is required to lift spending.

I’ll come back to that later but first lets look at how austerity Australian style impacts on our economy. 

 This change in household savings has one cause but many different facets. First and foremost is too much debt. Households have acknowledged they hold too much debt and that they need to pay this down as soon as possible – or at least redress the imbalances they feel and see in their personal finances of all is that an increased debt burden, or at least an acknowledgement that it is probably too high, means that savings go up – that much is easy.

But I think a commonly misunderstood aspect of Australian austerity is that when spending is to be done it is evaluated and compared on “value” grounds extremely aggressively. Why the overseas holidays? They are often cheaper – add in the spice of the exotic and it’s an easy decision. Why internet purchases, once again they are cheaper. Why are we seeing restaurants and cafe retail sales doing ok – treats and small luxuries. So it’s not as if Australian consumers are hiding in their bunkers and not spending it’s just that they are being more discerning and that the free spending many businesses had been used to over the past 2 decades and on which many business plans had been built just is not happening. So some sectors, non-mining, of the economy can feel like they are in recession at the moment.

So, you may ask, if that is the case how will an interest rate cut help the sectors under pressure, won’t there just be more overseas holidays and internet purchases?

The risk is certainly there but with the savings rate having moved up to a level that is consistent with the long run average of household saving then spending should, in theory, increase along with the increase in income. Income will rise in line with the annual increases each worker gets, or should get, each year. BUT income can also rise from a reduction in debt burden – an interest rate cut.

The RBA was worried about inflation. That fear now seems misplaced and with the Australian economy under pressure now is the time for a cut. No need to wait

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