Virtually everyone who follows these matters expects the Reserve Bank to cut interest rates today, with some people predicting (or calling for) a cut of 50 basis points. Inflation is low, non-mining activity is weak and the government has promised a substantial fiscal tightening. Those are the arguments of 'double whammy' proponants.
Internationally, the China boom is slowing, the American recovery may be fading and the Eurozone is in recession with the continued possibility of a disorderly breakup of the single currency union.
A cut of either 25 of 50 basis points would be acceptable, though this writer leans to the lesser cut for reasons to be explained.
The key aspect of the domestic economy is that a massive investment boom is underway. Mostly this is private investment in great mining projects, though government-funded infrastructure spending is also vital if Australia is to take maximum advantage of the mining boom.
Sadly, the need to restore fiscal stability, and advertise in clear terms that actions to achieve this are being followed, seems likely impose upon us all a sharp fiscal tightening. This would have been avoided if more restraint had been maintained during the crisis and especially if stimulus had consisted of spending or other reforms to raise productivity instead of wasteful ‘Keynesian’ stimulus, almost on a par with digging holes and filling them in again. (In the case of pink batts, the analogy is exact.)
Achieving even a modest surplus when tax receipts are low and the budget deficit still expanding will involve cutting spending in a number of areas, including highly desirable spending on infrastructure, defence and welfare policy. There will also, it seems, be extension of means tests and other actual or covert tax hikes whose net effect will be to reduce incentives to work hard and to innovate.
The Reserve Bank’s clear mandate is to keep goods and services inflation under control while maintaining overall financial stability. The very low ‘headline’ inflation for the March quarter included some one off price falls, including fruit and vegetables. But this point aside, low global inflation and a rising Australian dollar meant that so-called ‘tradeable goods’ inflation was especially low, in a number of cases negative.
Low or even negative traded goods inflation was sufficient to mask a noticeable increase in prices of ‘non-tradable’ goods. ‘Non-tradeables’ inflation (‘home made’ inflation) rose by 1 % in the quarter or 3.6 % over the year. Areas which experienced price rises were: education, up by 6 % in the quarter (with a whopping 7.7 % rise in secondary school prices); recreational, sporting & cultural services 2 %; veterinary & pet services 1.1 %; health 4.4 % (due to Pharmaceutical Benefits changes); utilities 2.1 % (including electricity up by 3 %); rents +1 %; petrol 2.5 %; and urban transport fares 4.6 %.
Home made inflation was sufficient in the March quarter to keep average prices rising despite the welcome traded goods deflation, reinforced by a rising Australian dollar. The dollar, of course, is already falling, and this may well increase with a rate cut today and if the promised budget deficit is credible.
The big swing factor is the investment boom already underway. This is predicated on continued strong commodity prices, and one assumes that falls already seen in commodity prices are properly factored into the mining companies’ plans.
Chinese economic growth has slowed to a ‘mere’ 8 % annual rate. There is general belief that China’s growth is unlikely to dip further, but I am less certain than most about this matter. China’s inflation reached a recent peak of over 5 %, then fell and most recently has revived somewhat. China’s leaders may feel that cheaper commodities would be a suitable reward from a more subdued economy and if that is the case the froth will come off Australia’s mining boom.
For some months the American recovery seemed to be stronger than generally expected, and corporate results have surprised on the upside. Yet the latest jobs figures suggest at least a stumble in the American recovery, and the US Fed has warned that recovery will be slow. The global benefit of this is that US interest rates should be lower for longer. US Fed Chief, Ben Bernanke has reiterated his position that US cash rates are likely to remain at approximately zero until late 2014. Zero cash rates in the USA is simply unsustainable.
The Eurozone crisis stumbles on. Germany is trying to force every other Eurozone country to embrace German work habits and industrial success, while simultaneously benefitting from a low Euro precisely because of the reluctance of the Club Med nations to come in from the beach and to begin working like joyless Germans. The Dutch government failed to implement a Germanic austerity plan and was forced to resign. France is busy electing a socialist president. Spain is struggling to meet its debt repayments and Spanish bond yields hit the recognised danger point of 6 %. Greece and other weaker nations have defaulted or soon will, entering into schemes of arrangement to pay only small proportions of their debts, like the land booming tycoons after the bubble burst in Marvellous Melbourne in the 1890s.
The overall global view is little changed, but the potential for fresh drama is clearly present. The Reserve Bank probably has no choice but to cut rates and therefore in doing so accept some criticism for having misread the economy. Such criticism is unfair, but even the flinty-eyed Glenn Stevens will feel he has to give some ground to his critics. But it would be wise to keep some powder dry in case the international situation deteriorates markedly.
Conversely, maintaining a firm grip on the economy provides some insurance against the possibility that a demoralised labor movement decides to grab what it can before the change of government that looks increasingly certain. Both the international uncertainties and the domestic risks suggest the need to cut by 25 basis points rather than 50 at this time.
The general outlook is for a long period of slow growth as nations, firms and households reduce leverage, cut debts, save more and consume less. Ideally, as well as fighting fires, political and official leaders would be rethinking the ways in which growth became unsustainable in the past 30 years and how to encourage more sensible, less resource intensive growth in the future.
Sadly there is little signs that this is happening, and the prevailing ethos seems to be restoring the Club Med culture was quickly and as thoroughly as possible. Nations that maintain a firm monetary policy and restore a sound fiscal policy will do better in this time of relative austerity.
Published today in The Australian.
Technical note: inflation since 1959.
Below is a graph of several measures of inflation, including the important measure of inflation expectations. (Thanks to Julian McCrann of Roy Morgan Research for this graph.)
The inflationary surge that lasted from 1970 to 1990 did great damage to the Australian economy, killing the traditional culture of saving and causing the rate of unemployment to exceed 10 per cent, a level that has taken decades to (largely) fix.
The key point is that 'headline' is now temporally low but consumer inflation expectations are stubbornly higher, being 3.3 % for the months of both March and April.
Only time will tell if inflation expectations will fall, or headline inflation will rise. This dissonance will, however, eventually be resolved one way or another.