The downbeat outlook for the economy as reflected in this past week’s Mid-Year Economic and Fiscal Outlook suggest the Reserve Bank of Australia may well cut interest rates in the New Year – despite the recent declines in the Australian dollar.
The MYEFO continued to forecast below trend economic growth this financial year of only 2.5%. And Treasurer Joe Hockey conceded the unemployment rate was likely to rise further – reaching 6.5%, and staying there until June 2016.
The so-called transition from mining to non-mining led economic growth is underway, but it’s a slow agonising process.
It’s likely that the negative headlines surrounding the growth outlook, together with the large upward revision to the budget deficit to $40 billion this year, could take a further toll on consumer and business sentiment in the months ahead.
History suggests a falling Australian dollar also tends to unnerve household sentiment, though it might provide some support to business confidence – especially in the trade-exposed sectors.
Of course, the RBA has conceded that interest rates are already quite low and are far from holding back the economy. In this regard, lower interest rates might not provide much of a direct extra boost to the economy. And some might argue lowering interest rates further could have a perverse effect on the sentiment, by highlighting the economy’s weakness.
That said, if sold correctly, lower interest rates should more help than hurt sentiment. Indeed, the RBA won’t want to cut rates and use the weakness in the economy as the main justification. Rather, it would prefer to tell a “good news story” of sustained low inflation making it possible to reward the economy with another rate cut.
In this regard, the December quarter consumer price index report – due out in late January – looms large. If the CPI result shows underlying inflation remains quite contained, the RBA might use this as justification to nudge interest rates lower at its first meeting of the New-Year in February. It might then also switch to an easing policy bias, suggesting another rate cut is possible if the Australian dollar remains uncomfortably high. Such a bias – even if not acted on for another few months – could help pressure the $A even lower and provide further impetus to the housing sector, which is already showing tentative signs of slowing.
Also creating room for a rate cut are new lending guidelines by the Australian Prudential Regulation Authority (APRA) that banks contain annual growth in lending to property investors to no more than 10 per cent. This new form of “macro-prudential” control is a bit clumsy, but it could help reduce the main risk of lower interest rates – that of sparking an investor led bubble in property prices.
As for the Australian dollar, some might argue that its marked decline from the low US90c level to low US80c level should be stimulus enough. But that ignores the fact the $A has fallen precisely because export commodity prices have fallen, which is reducing national income. In other words, fair-value of the $A has also declined – such that even at today’s level the $A is arguably still overvalued. Indeed, in a recent interview, RBA Governor Glenn Stevens suggested he would prefer to see the $A closer to US75c than US85c.
We also need to remember just how overvalued that $A had become. In fact, for the $A to equal it long-run real value in the post-float period (allowing for inflation differentials between Australia and the United States), it would need to fall all the way back to US70c.
All up, the good news for investors and the economy next year is that a weaker $A and probably more active central bank could help kick start a lift in growth and corporate earnings. That’s just as well, as the Abbott Government remains so obsessed with the budget deficit – half of which I estimate is caused by the weak economy anyway – we can’t expect much help from Canberra.
