Economic and Financial Market Update: Be Careful What You Wish For; Interest Rate Outlook

Summary:

• The RBA looks for an improving economy;

• Stronger mining capex is part of that story;

• ‘Unconventional’ monetary policy is unlikely to start until the cash rate hits 0.25%;

• Negative cash rate is unlikely to be implemented;

• The RBA is likely to require help to get the economy moving.

"So be careful what you wish for, 'cause you just might get it

And if you get it, then you just might not know what to do with it

'Cause it might just come back on you ten-fold"

- Eminem

Monetary Policy

Over the course of this year there has been plenty of discussion about monetary policy in Australia and the possibility of ‘unconventional’ monetary policy. The RBA Governor (Phil Lowe) gave a recent speech on the conditions of when ‘unconventional policy’ might be used in Australia. 

The RBA is forecasting a better economy and so does not think ‘unconventional’ policy will be necessary. The RBA has a laundry list of positive factors about why the economy will improve:  very low interest rates, a weak exchange rate, tax cuts, rising mining capex and strong infrastructure/NDIS spending.  The RBA also notes the pickup of house prices in recent months, although to date that has mainly been a Sydney/Melbourne phenomena.

But the economy faces significant headwinds. The global economy is a clear concern. The downturn in residential construction over the next year could be sharper than the RBA expects (although that could then mean a sharp rise in construction in the subsequent year, or two). The consumer remains cautious, worried about high debt, modest wages growth and (now) growing signs of slowing jobs growth. Firms (particularly outside of mining) looked to have cut back the size of their investment budgets for this financial year.

While the RBA does not think that unconventional policy is likely they acknowledge it is a possible scenario. In his speech, Governor Lowe made the following points:

• Consideration of ‘unconventional’ monetary policy would not take place until the cash rate hits 0.25% (currently 0.75%);
• The use of negative cash rate in Australia is unlikely as the problems (such as a big impact on the banking sector) are potentially large;
• More likely is the RBA buying Government bonds to help drive down longer-term interest rates (known as quantitative easing, or QE). Purchases of non-Government assets by the RBA is unlikely, and only likely to occur if there is a serious problem in financial markets.

If the RBA did undertake QE there would also likely provide ‘forward guidance’ (the RBA indicating where they believe the cash rate will go in the future). The RBA would provide either explicit guidance that the cash rate will not move until a stated time or until a particular economic objective (higher inflation or lower unemployment rate) is achieved.

At the time of writing financial markets had fully priced another quarter percentage point rate cut by May next year, and some chance of a second in the second half of next year. So financial markets currently agree with the RBA that unconventional policy is unlikely.

Fiscal Policy

As Eminem notes, you need to be careful for what you wish for. For much of the past couple of decades ever lower interest rates was seen as a good thing. Now there is increasing agreement that further cuts to interest rates are unlikely to provide the economic punch that is required. 

And that is the reason why there has been growing clamour that the economy needs more fiscal support. Infrastructure spending is currently strong. But the low level of both interest rates and debt means the federal government can afford to keep the investment spending taps on. And years of underinvestment and very strong population growth means more infrastructure spending is required. Surveys indicate that Australia is falling down the ladder of world infrastructure rankings.

But it is not easy to deliver on lots of large, complex projects at the same time. Both budgets and timetables are typically underestimated. Bottlenecks appear. There have been reports of shortages of engineers (although vacancy levels are below pre-GFC times). The bulk of infrastructure spending is the responsibility of State governments. And State debt is on the rise. To date there has been no credit rating implications. But the States are starting to face budgetary constraints. 

Substantially more infrastructure spending is required. And (in time) will likely be delivered. But it might be hard to significantly ramp up more projects to get the economy moving over the next 2-3 years.

There have also been proposals to boost spending on infrastructure maintenance as well as undertaking smaller projects (such as building car parks). Both reasonable ideas. Bringing forward the tax cuts scheduled for 2024-25 has been another proposal. The concern would be that a good chunk of the cuts could be saved given households current risk averse state.  Less discussed is a boost to R&D spending, something that is currently low by OECD standards and an important plank for Australia to become a more innovative economy. 

More generally now is a good time for the Government to look at policies to boost productivity. In recent years Australia has not done too badly on the global competitiveness front. But productivity has been slowing over the past couple of years.  And it is the strength of productivity growth that over the long-term is the key driver of how much living standards can rise.

‘Be prepared’ is the famous motto of the Scouts. The RBA gave a ‘be prepared’ speech on a possible roadmap for the future of monetary policy to help the economy. If that roadmap has to be used, more than unconventional RBA policy will need to be used to support the economy.

We live in interesting times!

Peter Munckton - Chief Economist