Australia urgently needs an interest rate cut

Mon, 26 Mar 2018  |  

This article first appeared on the Yahoo7 Finance website at this link: https://au.finance.yahoo.com/news/australia-urgently-needs-interest-rate-cut-231554621.html 

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Australia urgently needs an interest rate cut

The Australian economy urgently needs an interest rate cut, or two, if there is to be a pick up in activity, lower unemployment, higher wages growth and for inflation to move back to the RBA target range.

The RBA last cut interest rates in August 2016 to 1.5 per cent, having dragged the chain to cut to even that level when the bulk of the industrialised world had already had the benefits of years of near zero interest rates and, in many cases, quantitative easing. This is not to say that Australia needed zero interest rates or QE, but official interest rates below 1.5 per cent a year or two earlier would have helped support growth and not seen Australia stand out like a sore thumb with a lack of progress on reducing the unemployment rate and returning the economy to optimal growth.

Of course, the RBA was worried about house prices. Its problem was its strong philosophical objection to regulatory changes to limit lending for housing, especially investor housing. Had it embraced these changes earlier, it would have been able to cut rates to help the business sector be the lynchpin of stronger growth while the housing market softened.

Thankfully, on the issue of changes to lending regulations, the RBA was left on the sidelines. APRA and other regulators imposed restrictions on bank lending which are now clearly having an impact on the housing market. 

When the last interest rate cut was delivered in August 2016, the RBA noted a number of critical points and provided a set of forecasts for the economy that it hoped or expected monetary policy would help to deliver.
Importantly, the RBA noted that: “GDP growth is expected to be around 2.5 to 3.5 per cent over 2016, before increasing to around 3 to 4 per cent by 2018”.

Unfortunately, GDP growth ended 2017 at 2.4 per cent with little prospect of a pick up to even 3 per cent any time during 2018, something the RBA now acknowledges. This is especially the case with the slowing in housing, moderate growth in consumer spending and tepid rise in business investment unfolding.

Yet it still does nothing with official interest rates.

When rates were cut in August 2016, the unemployment rate stood at 5.6 per cent. The disappointing growth rate in the subsequent year and a half has meant zero progress on reducing the unemployment rate which is still 5.6 per cent in the latest labour force release.

This is a significant failure when most other industrialised countries have their unemployment rates well under 5 per cent and in some cases near 4 per cent. While Australia’s unemployment rate has gone nowhere, in part due to relatively high interest rates, the rest of the world has activity used monetary policy to drive unemployment lower.

The RBA also had a forecasting error for inflation. It noted that “Underlying inflation is expected to remain around current rates in the near term, before picking up gradually to around 2 per cent”.

The latest data show annual underlying inflation at 1.9 per cent, not a huge error, but an error nonetheless. It has been below 2 per cent every quarter since the last rate cut.It is important to recall that the RBA has a target for inflation to be between 2 and 3 per cent and a goal of full employment.

While the RBA retains a positive outlook for the economy, the hard facts remain problematic. Even its own forecasts do not have inflation returning to the target range in the coming year and its forecast for GDP growth is among the most optimistic of any forecaster in Australia.

This is unusual.

With regulatory changes driving a welcome soft landing for the housing market and a surge in new dwelling supply from the construction boom still flowing through to the economy, the RBA should cut interest rates to 1 per cent, perhaps less. This would not only allow the tepid uptick in business investment to gather support, but it would likely see the Australian dollar fall to give exporters a competitive edge at a time when the tariff wars threaten global trade.

Lower interest rates are a policy that, unlike tax cuts, cost the budget zero month (they actually help to improve the budget bottom line as growth and inflation pick up). Interest rate cuts can easily and quickly be reversed if or when there is good news on the economy and inflation moves back to the target range and wages growth picks up as the unemployment rate falls.

The US Federal Reserve is showing how this can be done with the solid growth and low unemployment rate from the earlier episode of easy monetary policy now being reversed.

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