A drop on the horizon

By Saul Eslake

Since 1867, the first Tuesday in November has been the day of ‘the race that stops the nation’, the Melbourne Cup. For each of the last five years, it’s also been a day on which the Board of the Reserve Bank of Australia has adjusted official interest rates (which means that it isn’t a holiday for economists who follow these things closely), and it looks like this year will be no exception. For the sixth year in succession, the Reserve Bank Board is likely to change interest rates on Melbourne Cup Day – this year, unlike the previous five, it’s likely to be downwards.

The Reserve Bank laid the groundwork for a cut in interest rates at last month’s meeting. Although it left interest rates unchanged, it noted that there could soon be ‘scope for monetary policy to provide some support to demand, should that prove necessary’.

This is a significant turnaround from the judgement that the board has made at each meeting since November last year, when it last lifted interest rates, that ‘the current mildly-restrictive stance of monetary policy remained appropriate’. Indeed, as recently as its August meeting, the board was considering whether “further policy tightening” (that is, another increase in interest rates) was “warranted”.

So what’s changed?

What hasn’t changed is the Reserve Bank’s assessment of the magnitude and consequences of the resources boom. ‘National income has been growing strongly’, the Board noted after last month’s meeting, and ‘investment in the resources sector is picking up very strongly’. And, notwithstanding the heightened volatility in global financial markets since early August, and the downgrading of the growth outlook for Europe and the United States, it still regards the ‘central scenario’ for the world economy over the next couple of years as being one of growth ‘at or above long-term averages’.

However, there are two important things that have changed over the past few months, and by enough to prompt a clear shift in the Reserve Bank’s thinking.

Shift in attitude

The first of these is the ongoing shift in Australian households’ attitudes towards borrowing and spending, which the Reserve Bank Board now thinks is ‘likely to keep some areas of demand weaker in the near term than earlier expected’. Australian households are now saving more than 10 per cent of their disposable incomes, up from two to four per cent immediately before the onset of the global financial crisis, and in marked contrast to the years 2002 through 2005 when Australians were, in aggregate, spending more than they earned.

The mirror image of this substantial increase in household saving is that growth in household borrowing has slowed to its slowest pace since the recession of the early 1990s, and below the growth rate of household disposable income. As a result, the household debt-to-income ratio has fallen from a peak of 158 per cent in the June quarter of 2010 (after the surge in borrowing triggered by the record lows to which interest rates fell after the financial crisis, and the temporary increase in government assistance to first home buyers) to less than 154 per cent in the June quarter this year. That’s the lowest level since the March quarter of 2006. Australians are clearly seeking to put their finances on what they consider a more sustainable footing. Fortunately, from the standpoint of the stability of the Australian financial system and the residential property market, they’re doing it by paying back debt, rather than by defaulting on it (as many Americans have done).

The downside of all this is that Australians are spending a smaller proportion of their income than at any time since the mid- 1980s. They’re still spending on services – including overseas holidays – but they’re not spending nearly as freely on goods, particularly those sold by Australian bricksand- mortar retailers. That’s the main reason many retailers are experiencing their most difficult trading conditions since the recession of the early 1990s.

Outlook on inflation

The second important change is in the outlook for inflation. For much of the past year, the Reserve Bank has been worried that the resources boom would result in inflation moving above its two to three per cent target band, as capacity in the domestic economy tightened and the effects of subdued retail trading conditions and the strong Australian dollar in dampening price pressures waned. The Reserve Bank’s most recent formal forecasts, issued in early August, envisaged the ‘underlying’ inflation rate (that is, inflation excluding the impact of large fluctuations in the prices of bananas, petrol etc) exceeding three per cent for most of the period between the December quarter of this year and the end of 2013.

That prospect was reinforced by the June quarter CPI figures which, when released in the last week of July, suggested that, for the second consecutive quarter, ‘underlying’ inflation had been running at an annualized rate of more than three and a half per cent.

Since then, however, the Australian Bureau of Statistics has released revised CPI figures based on more up-to-date patterns of consumer spending and (for the first time) adjustments for seasonal influences on the behaviour of prices: and these figures suggest that ‘underlying’ inflation was running at just under three per cent during the first half of 2011, or slightly more than half of one percentage point less than previously reported.

In addition, with the unemployment rate now having risen by almost half of one percentage point since April, the Reserve  Bank thinks ‘the likelihood of a significant acceleration in labour costs outside the resources and related sectors is lessening’.

The bottom line is that the Reserve Bank seems to have lowered its near-term forecasts for both economic growth and inflation – something which will be confirmed when it releases its next quarterly Statement on Monetary Policy three days after the Melbourne Cup Day Board meeting, and just over a week after the release of the September quarter CPI.

If, as Glenn Stevens said in his statement following the Reserve Bank board’s October meeting, “the pace of near-term growth is unlikely to be as strong as earlier expected” and “the path for inflation may now be more consistent with the two to three per cent target in 2012 and 2013”, then the rationale for maintaining “the current mildly restrictive stance of monetary policy” (as the Board has described it after each of its meetings since it last raised interest rates on Melbourne Cup Day last year) is much diminished.

Getting back to neutral

A 25 basis point reduction in interest rates this month would take monetary policy settings back to ‘neutral’, which would be more appropriate for an economy in which inflation was expected to be around the mid-point of the Reserve Bank’s target band and where there were still ‘good reasons to expect solid growth over the medium term’ (as Glenn Stevens put it in October).

That would still leave the Reserve Bank with plenty of room to respond with larger reductions in interest rates should the outlook for the world economy deteriorate more sharply, for example if the US or European economies were to fall back into recession.

While that is a distinct possibility, it’s not sufficiently probable for the Reserve Bank to undertake large, ‘pre-emptive’ reductions in official interest rates. Almost certainly, Greece will default on a large proportion of its debts – and provided European banks can be recapitalised sufficiently to ensure that a Greek default doesn’t render any of them insolvent, it would probably assist in resolving the ongoing European financial crisis if it were allowed to do so. Provided a Greek default is managed in an orderly way, and the European authorities are willing to commit sufficient financial resources to convince markets that there will be no other sovereign debt defaults, the euro area as a whole should be able to avoid slipping into another recession. Meanwhile, although there’s certainly no indication that growth in the US economy has picked up from the meagre pace it eked out over the first half of 2011, nor are there any signs that it has turned negative. Rather, the most plausible scenario for both the US and the euro area economies is an extended period of anaemic growth, accompanied by persistently high unemployment and very low inflation.

Similarly, although the Chinese economy is undoubtedly slowing from the doubledigit pace of growth it recorded last year, that’s precisely what the Chinese authorities have been seeking to engineer: there’s no convincing evidence that China is headed for a ‘hard landing’. Moreover, although China’s exports will be affected by any further slowing in the US and Europe (its two principal markets), over 90 per cent of what Australia sells to China feeds into China’s domestic demand (urban infrastructure, housing and personal consumption), rather than into China’s exports. And it’s domestic demand that will be the target of any stimulus measures that China would undertake in the event of a sharper downturn in the ‘advanced’ economies.

Hence, although it’s not been common for the Reserve Bank to undertake ‘onceoff’ changes in interest rates – rather, a first change in one direction has almost always been followed by more in the same direction – a Melbourne Cup Day rate cut is unlikely to be the first leg of a quinella or trifecta.

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Saul Eslake is a program director at Melbourne’s Grattan Institute and an independent economic analyst. He was formerly chief economist at ANZ for 14 years. saul.eslake@grattaninstitute.edu.au

Article last updated 22 December 2011