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Australia’s inflation rate, at 1.3% (March quarter), highlights concerns about insufficient aggregate demand. For 10 of the past 12 quarters the headline inflation rate has been less than 2%, well below the Reserve Bank of Australia’s official target range of 2-3%. The unemployment rate ticked up to 5.2% in April and yields of benchmark 10-year government bonds have fallen to record lows. The RBA Shadow Board’s conviction that the cash rate should remain on hold next week weakened and the policy bias has further shifted in favour of a rate cut. More specifically, the Board attaches a 43% probability that holding interest rates steady at 1.5% is the appropriate setting, while the confidence in a required rate hike equals 8% and in a required rate cut equals 50%.
Based on latest ABS figures, the seasonally adjusted unemployment rate in Australia rose for the second month in a row, to 5.2% (April), coinciding with an increasing labour force participation rate (from 65.6% to 65.8%). Full time employment fell slightly, while part-time employment increased by nearly 35,000. There is growing concern among economists that the relatively high part-time employment rate in Australia reflects significant under-employment, which helps to explain why the comparatively low official unemployment rates in the past couple of years have not led to a surge in inflation. Again, there was no new data on overall wages growth. However, two days ago the Fair Work Commission announced that the national minimum wage will rise by 3% from 1 July, which should feed through to wages more generally and support consumption expenditure.
The Aussie dollar (relative to the US dollar) has finally broken the 70 US¢ barrier and is now trading near 69 US¢. With markets widely expecting Australian interest rates to remain low, and possibly fall further, the Australian dollar is unlikely to appreciate significantly. Yields on Australian 10-year government bonds, anticipating weakness in the Australian economy, have continued their decline and now stand below 1.70%. On Tuesday, the yield on Australian 10-year bonds slumped to 1.48%, the lowest level on record and below the official cash rate, implying that the yield curve, if only for a day, inverted. This reflects growing concerns about the future health of the domestic economy. Buoyed by the federal election and prospects of easing credit, the Australian share market rallied to new highs, to above 6,500 for the S&P/ASX 200 stock index.
The escalating trade war between the US and China poses a threat to both the global and Australian economies. Not only will this likely affect trade flows, but it will eventually affect capital markets and possibly increase global risk premia. US GDP growth and the official unemployment rate is at a record low of 3.6% but the labour force participation rate remains below 63%, while the yield curve has inverted for the second time this year. The European economies are unlikely to become an engine of growth any time soon, putting additional pressure on the rest of the world, in particular the emerging economies, to prop up global growth. Geopolitical tensions, e.g. the sabre rattling between the US and Iran, add to the overall risks.
Consumer performance measures are unchanged; business performance measures have not been updated since the last round. Likewise, there is no new data on the real estate sector. However, imminent tax cuts, the prospect of lower mortgage rates, as well as APRA’s relaxation of lending standards, are leading a growing number of economic commentators to suggest that the housing market may be bottoming out. The danger is that Australian households, already among the most highly leveraged in the world, are going to indebt themselves further, which poses macroprudential and economic risks in the future.
The outcome of the federal election means the opposition’s proposed tax reform, including the abolition of negative gearing and a revision of the franking credits system, is off the table. Instead, the newly elected government will look to pass its proposed tax cuts. Initially, these do benefit lower income households, which, combined with the announced infrastructure spending, might provide a small and brief fiscal stimulus. Down the track, however, the tax cuts favour high-income households who have lower marginal propensities to consume, suggesting the fiscal boost from the tax cuts will be small. Whether the government’s multi-year fiscal plan is implemented, depends on the health of the Australian economy for, if the economy does weaken and revenues fall short of the government’s optimistic forecasts, the government will likely revise its tax and spending policies.
The Shadow Board’s conviction that the overnight interest rate should remain unchanged has weakened further and it is now, on balance, slightly favouring a rate cut. The Board is 43% confident that keeping interest rates on hold is the appropriate policy, down eleven percentage points from the previous month. It now attaches a 50% probability that a rate cut is appropriate (compared to 38% in the previous month) and only an 8% probability (unchanged) that a rate rise, to 1.75% or higher, is appropriate.
The probabilities at longer horizons are as follows: 6 months out, the estimated probability that the cash rate should remain at 1.50% has dropped from 38% to 31%. The probability attached to the appropriateness for an interest rate decrease has increased from 38% to 51%, whence it only equalled 11% in February, while the probability attached to a required increase has fallen another five percentage points, to 19%. The numbers for the recommendations a year out paint a similar picture. The Shadow Board members’ confidence that the cash rate should be held steady dropped to 21%, down from 25%, while the confidence in a required cash rate decrease equals 46% (37% in May), and in a required cash rate increase 33% (38% in May). The distribution of the probability distributions over the 6 month and 12 month horizons are unchanged, extending from 0.25 to 3.0.
For 10 of the latest 12 quarters the inflation rate has been in the 1-2% range, consistent with the fact that inflation in Australia remains low and stable. But there is a problem with the inflation target being 2-3% when that target is so difficult to achieve given global factors and their influence on inflation, and structural changes in our economy. Now is not the time to cut rates, rather it is time to reset the inflation target to 1-3% to better reflect the Australian reality, and to avoid the pressure on the RBA to fruitlessly cut rates and create further distortions. I think that many economists have forgotten the pushing on a string analogy. At these levels of the cash rate further cuts in interest rates are unlikely to do much to stimulate the economy.
The recent decline in inflation to 1.3%, clearly below the RBA’s 2-3% target range, looks broad-based and provides a clear impetus for the RBA to cut the policy interest rate. Even a 50 basis point cut could be justified by the magnitude of the decline in inflation and the recent uptick in the unemployment rate to 5.2%. Furthermore, the RBA should signal that it will do whatever it can to bring inflation well back into its target range and not plan to raise rates at least until inflation is at the high end of the range and forecasts suggest strong risks of it persistently rising above the target range. The re-elected government’s plans for stimulative fiscal policy could help assist offsetting weaker demand in the economy. However, it is crucial that the RBA demonstrates its strong commitment to the current target range in order to keep inflation expectations stable and real interest rates low.
With the election settled and Labor’s extensive tax changes off the table, the risk of an asset-led recession has receded. Further to this, APRA (always in consultation with the RBA) has finally and belatedly responded to the macroprudential imperative and removed some of its onerous regulations on credit.
Nevertheless, the economic war between the US and China is getting more intense, and looks as if it may persist into the long term and spread more widely. This is a major source of the weakening of global economic growth, which will keep real interest rates low. Australia is significantly exposed to these global headwinds.
Inflation remains below the RBA target, output growth is below normal, and the underemployment gap is still high. The cash rate needs to be cut now and once again soon.
Updated: 26 September 2021/Responsible Officer: Crawford Engagement/Page Contact: CAMA admin
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