Interest rates could fall in 2012

By Saul Eslake

In January, the economic outlook seemed reasonably clear: Europe and the United States were recovering, albeit slowly, from the GFC; China was booming, and although inflation was rising it was manageable; and here in Australia the mining boom was getting back into full swing, having been only temporarily derailed by the financial crisis, and interest rates were expected to rise further in order to contain the inflationary pressures that the boom would inevitably bring.

Thus, in its first Monetary Policy Statement for 2011, issued in February, the Reserve Bank expected the world economy to grow by 4.75 per cent in both 2011 and 2012, the Australian economy to grow by about 3.75 per cent in 2011 and close to 4 per cent in 2012, and with ‘underlying’ inflation rising to the top end of its 2 to 3 per cent target band by the end of 2012. As recently as August, even though its forecasts for global economic growth had been shaved to 4.25-4.5 per cent per annum, and various natural disasters at the beginning of the year had slashed the forecast for 2011 growth in the Australian economy to just 2 per cent, the Reserve Bank had revised its forecast for 2012 growth up to 4.5 per cent, and expected ‘underlying’ inflation to be at the top end of the target band throughout the year.

But in its last Monetary Policy Statement this year, issued just after it cut interest rates for the first time since May 2009, the Reserve Bank’s prognosis for 2012 was decidedly more sombre. It now expects global growth of ‘only’ 4 per cent, but notes that the risks to that view are ‘skewed to the downside’. The forecast for growth in the Australian economy next year has been cut to 4 per cent – though that’s still a strong number, by historical standards. And the Reserve Bank now sees ‘underlying’ inflation (excluding the impact of the carbon price) running at the mid-point of its target range right through 2012 and into 2013. That leaves open the possibility that, contrary to what I foreshadowed here last month, there could be another reduction in interest rates in 2012. Two particular external influences will likely determine whether the Reserve Bank does cut rates again next year, and if so how many times and by how much.

The state of Europe

The first is the course of events in Europe. The Reserve Bank’s working assumption is that “the European authorities do enough to avert extreme financial dislocation, but are unable to avoid periodic bouts of considerable volatility and uncertainty”. That’s hardly a ringing endorsement of the European authorities’ ability to resolve the sovereign debt crises afflicting up to five European nations. And with each successive ‘bout of considerable volatility and uncertainty’, the possibility of ‘extreme financial dislocation’ becomes less remote.

There is now a non-trivial possibility that Greece could default on its debts in a disorderly way, triggering payouts on credit default swaps (something which the European authorities have been especially anxious to prevent, mindful of the role which these instruments played in spreading ‘contagion’ in the aftermath of the collapse of Lehman Brothers). And the pressure is mounting on Italy, whose sovereign debt is the third largest in the world, exceeded only by the United States and Japan.

The new head of the European Central Bank has conceded that the euro zone may have already slipped back into recession – that’s why, at his first opportunity, he unwound one of the two rate increases his predecessor unwisely implemented earlier this year. The further austerity measures which Italy and France have enacted or foreshadowed in recent weeks could be enough on their own to make another euro zone recession a certainty. A disorderly Greek default could well do the same.

Should Europe fall back into recession, it would likely be a long one, because the European authorities don’t have the tools to respond to it in the way that central banks and governments have typically done since the 1930s, and as they did to the recession induced by the financial crisis of 2008-09. The European Central Bank can only cut interest rates by 1.25 percentage points (and its previous form suggests it won’t cut them by that much); and European governments are already committed to fiscal austerity, rather than to renewed fiscal stimulus.

Although Europe doesn’t matter to Australia as much as it used to (it takes less than 7.5 per cent of our exports, half as much as at the time of our last recession in the early 1990s), an ‘extreme financial dislocation’ in Europe would still affect Australia through its impact on confidence, and on financial markets.

Fortunately, it now seems less likely that the US economy will slip into a second recession, although the medium-term outlook for the US economy is hardly encouraging – nor are the prospects for putting American public finances on a sustainable long-term footing in what will be a bitterly contested election year.

China slowdown

The second important external influence on the Australian economy next year will of course be what happens in China and – in consequence – the course of commodity prices.

China’s economy is clearly slowing, and perhaps by more than suggested by the official GDP data, according to which China’s economy grew by 9.1 per cent over the year to the September quarter. It’s important to remember, though, that the Chinese authorities have been explicitly seeking a slowdown in China’s growth rate, in order to keep a lid on inflation and to reverse the buildup of potentially destabilising speculative pressures in China’s urban property markets.

Chinese inflation does appear to be receding, from a peak of 6.5 per cent over the year to July to 5.5 per cent over the year to November, a decline that is mirrored in ‘upstream’ price indices. There are also clear signs that the progressive tightening of monetary policy since early 2010 is beginning to bite – and that’s the most sensible way to interpret signs of distress in parts of China’s informal financial system, something which is inevitable when a formal banking system is subject to tight controls as China’s is.

Given the slowing in China’s economy, and the fact that increases in the supply of some commodities are starting to come on stream, it’s not surprising that commodity prices have fallen from their recent peaks. The extent of speculative investor interest in commodities has also diminished in line with the more risk-averse stance of global investors during the most recent bout of turbulence in financial markets. Iron ore prices have fallen some 30 per cent from their September high, base metal prices are 20-35 per cent off their peaks and even the gold price, which had continued to rise almost irrespective of sentiment in other markets until early September, is down almost 8 per cent since then.

If commodity prices continue to decline – as they would, and more rapidly, if China were to have a ‘hard landing’ – then one of the most important sources of growth in Australia’s national income would become significantly weaker. Even then, however, it should be remembered that the investment phase of the resources boom is now much more firmly entrenched than it was just over three years ago. Moreover, in my view the chances of a sustained ‘hard landing’ in China’s economy are still quite small.

The reserve bank

The Reserve Bank will also be paying careful attention to developments in the domestic economy. It’s perhaps worth emphasizing (again) that the Reserve Bank sets interest rates according to its expectations for the performance of the economy as a whole, rather than according to the experience of or prospects for individual sectors of the economy. The difficulties faced by some sectors, such as tourism, retailing or manufacturing (see page 30), won’t have any impact on the Reserve Bank’s monetary policy decisions if they are offset by strength in other sectors, such as mining or engineering construction. Indeed, the Reserve Bank actually welcomes the softness in retail sales, because it is helping to make room for the expansion of the mining sector in a non-inflationary way – something which Australia has been unable to achieve during previous commodities booms. Moreover, the increase in household saving – to its highest proportion of disposable income since the mid-1980s – has also enabled the upsurge in mining investment (and the swing in the federal budget into deficit) to be financed without a blowout in the current account deficit to over 6 per cent of GDP. Indeed, in the most recent financial year 2010-11, Australia’s net borrowing from foreigners was smaller, as a proportion of GDP, than in any year since 1980.

It is, of course, true that the sectors which have been at the ‘wrong end’ of Australia’s ‘two-speed’ economy are, in most cases, significant employers – and that, as a result, the unemployment rate has ticked up by a little over 0.25 percentage point since April. The likelihood is that unemployment will rise further, probably to somewhere between 5.5 and 6 per cent, during 2012. That has served to diminish substantially the Reserve Bank’s fears that upward pressure on wages and salaries in the resources sector would spill over into other parts of the economy, interacting with very poor productivity growth to generate unacceptably high inflation rates (as has happened during previous commodities booms).

Hence it’s possible that the first half of next year could bring another cut in interest rates. But it would take a more serious downturn in the global economy, whether emanating from Europe or China, to justify expectations of large reductions in interest rates. And it’s doubtful that anyone would seriously wish for that.

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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