Late last year I suggested the Reserve Bank of Australia “may well cut interest rates in the new year”, though with hindsight I was not strong enough with my view. The glory in making such a bold call went to other economists such as Bill Evans at Westpac.
To add insult to injury, I then eventually argued against speculation that the RBA would cut as early as February. It did. And having got that call wrong I then suggested the Bank would cut again this month. It did not.
So you could say I’m batting zero for two in my near-term interest rate calls, even though I still feel I’m on the right side of the general direction in the economy and interest rates.
With due humility, I’m now arguing the RBA will again likely cut either next month or in May ( I won’t try to fine tune this timing this time around). More importantly, however, I also suspect the RBA will go further – and end up having to cut interest rates to 1.5% later this year.
My view is based on the RBA’s own reasoning. If my call on the economy is right and the RBA remains consistent in its thinking, it will have no choice but to cut rates substantially more.
How so? Note the RBA did not decide to cut interest rates in February because it thought the economy was getting weaker. Rather, as noted by Deputy Governor Phillip Lowe this week, it was “rather because of the lack of compelling signs that economic growth was picking up as was earlier expected."
Indeed, the RBA has been counting on the economy returning to a “trend” pace of growth by the second half of this year. That expectation has now been pushed out until the first half of 2016. And this in turn is still based on an eventual uplift in non-mining investment, and firmer pace of consumer spending.
It’s the fact that recent economic conditions have remained mixed – i.e. have not notably deteriorated – that caused many financial market economists to miss the RBA lurch back to an easing policy bias. But the RBA has effectively lowered the bar for lower rates – the economy does not need to get worse, only fail to improve.
Lowe also noted in his speech this week that while lower interest rates appear to be boosting housing construction and home and equity prices in the usual way, the impact on consumer spending – which account for almost 60% of national output – does not appear as big as in the past. In this regard, interest rates have lost their punch.
In turn, that’s because the capacity of households to leverage up is more constrained as debt is now already high. Global and technology has also left us more fearful about our jobs. And the swelling ranks of retirees among us are relying on interest income to support their retirement.
The fact that interest rates don’t work was well as in the past might suggest we should use other levers to support the economy – such as higher government-led spending on infrastructure. But given Canberra’s budget deficit problem, that’s just a pipe dream.
At the end of the day, we’ve only got interest rates – and if they’ve lost their punch, it means the RBA will simply need to punch harder. After all, the RBA has a mandate to ensure the economy is as close to fully employed as possible without causing inflation. We’re far from that situation and the RBA’s can’t sit on its hands.
Meanwhile, I suspect the economy is not going to rebound as nicely as the RBA is currently hoping. Indeed, a recently released capital spending survey suggested that non-mining investment will fall rather than rise in 2015-16, at the same time as mining investment is expected to slump further. Consumer spending, meanwhile, remains patchy – not help by the fact that the unemployment rate is at 12-year highs, and wage growth is barely keeping pace with inflation.
Should the RBA cut again in coming months – as I suspect it will – it’s likely to then pause for a few months to assess the impact on the economy. Should the economy remain as weak as it is now later this year, however, the RBA will likely feel obliged to cut interest rates again – for the very same reasons that it cut interest rates earlier in the year.
