The RBA kicked off an easing cycle with this week’s 0.25% cut in the cash rate to 7%.
Then the National Accounts for the June quarter confirmed that we are having a sharp slowdown in domestic demand with household consumption falling in the quarter for the first time since 1993, but business investment strong, especially in mining.
But it is clear from the accounts that this domestic weakness, which is what the RBA has wanted to achieve to free up room for the export economy to continue growing without adding to inflation, may have come upon us more quickly than forecast.
Annual growth in the year to June was 2.7%, which is where the RBA expected us to be in a year’s time and we should start expecting to see job losses boosting labour force figures from now on, starting with the August numbers which are out next Thursday.
As reported above, there are growing concerns about political stability in Asia, although China still looks solid despite some concerns about demand for steel and steelmaking materials.
While the RBA was circumspect about future moves the AMP’s chief economist, Dr Shane Oliver says we can expect the soft economic conditions to result in more cuts taking the cash rate to 6% in a year’s time.
He says "one rate cut won’t see a sustained improvement in the economy or shares, but it’s going in the right direction."
For the first time since December 2001 the Reserve Bank of Australia has cut interest rates, with the official cash rate falling from 7.25% to 7%.
The recent run of economic data and anecdotal evidence suggests the significant slowdown in domestic demand the RBA has been looking for in order to slow inflation is underway.
Without an easing in financial conditions a hard landing, if not recession, was looking increasingly likely.
The RBA statement announcing the cut was relatively circumspect about the prospect of more rate cuts and highlighted the balancing act between high inflation and weak overall demand growth.
But the RBA has left the door open for further cuts and it is likely interest rates will fall further as sub-par growth adds to confidence that inflation will fall.
Rate cuts and the economy
Rate cuts are good news for the economy.
The tightening in financial conditions as a result of 12 consecutive 0.25% increases in the official cash rate since May 2002, an additional 0.5 to 0.6% increase in bank lending rates on the back of the credit crunch, a 30% slump in the share market, falling house prices, the surge in petrol prices and the $A near parity were all combining to significantly increase the risk of recession in the economy.
While the July tax cuts and Budget goodies worth about $50 a week for a typical family were nice, they were more than offset by an extra $75 a week in interest payments since mid last year and an extra $20 a week in petrol bills faced by a key consumption driving family with a $250,000 mortgage and two cars.
The result has been an abrupt downturn in the economy evident in a slump in consumer and business confidence to recessionary levels, falling retail sales volumes in the March and June quarters, a slump in housing related indicators, a sharp slowing in credit growth and a softening job market.
The list of companies announcing major layoffs has gone from a trickle to a torrent over the last couple of months, and includes: Holden, Ford, IAG, Qantas, Starbucks, Don KRC, NAB, Cadbury, Boeing, Fairfax, Babcock & Brown and Allco.
Fortunately, the RBA has seen the evidence and has done an about face. However, there are several things to note.
One cut on its own won’t have a big impact.
For a family with a $250,000 mortgage a 0.25% cut in interest rates amounts to a $12 a week saving.
But this is a long way from reversing the extra $75 a week needed to service the mortgage when mortgage rates rose from 8.05% mid last year to just over 9.6% in July.
Household interest payments relative to household disposable income will still be pretty close to record levels. (See the chart below.)
Secondly, the lag from rate cuts to the economy is long and variable, usually around 12 months or so.
Given that the massive tightening in financial conditions over the last year is still working its way through the economy, it’s likely we will see a further deterioration in economic growth over the next six-12 months or so.
In fact, our leading indicator (based on building approvals, business and consumer confidence, the share market, the shape of the yield curve and money supply growth) is still falling.
In addition to this, the worsening slump in the global economy with Europe and Japan reporting negative growth in the June quarter, the US remaining very weak and Asian countries including China and India now starting to slow suggests further downwards pressure on commodity prices, which may start to soften the mining boom in the short term.
It’s also worth noting that rate cuts haven’t yet prevented economic slumps in the US, UK and Canada.
This suggests more rate cuts are likely. But what about inflation?
The slump in growth suggests inflation will fall and this will be helped by falling oil prices. With growth likely to remain sub-par and inflation likely to fall over the year ahead our assessment is that the cash rate will fall to around 6% over the next 12 months.
Applying the normal lag and assuming more rate cuts, the c
