The rest of the world is cutting interest rates, so why aren’t we?

The dire picture of the Australian economy provided by this week’s national accounts produces a conundrum. If the economy is so weak, why are interest rates so high?

In other developed economies, central banks have started cutting or, in the US, are about to start cutting policy rates that surged to decades highs in response to the post-pandemic global outbreaks of inflation.

The European Central Bank, the Bank of England, the Bank of Canada and even the Reserve Bank of New Zealand have already reduced their equivalents of the Reserve Bank’s cash rate. The US Federal Reserve Board is expected to make the first of a series of cuts later this month.

Reserve Bank governor Michele Bullock has a dilemma.Credit: Alex Ellinghausen

Yet our cash rate is stuck at 4.35 per cent, its highest level since the lead-up to the global financial crisis in 2008, with our inflation rate of 3.8 per cent proving more stubbornly resistant than those of peer economies.

That puts the RBA in an invidious position, given the bleak picture of the economy provided by this week’s data.

Australia’s economy is essentially flatlining, growing only 0.2 per cent in the June quarter and a paltry 1 per cent for the year. That is, if you exclude the pandemic period, the most anaemic growth since the “recession we had to have” in 1991.

And the number was only positive because of public sector spending and population growth.

As many have noted, on a per capita basis, the 0.4 per cent fall in GDP in the June quarter means there have now been six consecutive quarters where GDP per capita has gone backwards. You’d have to go back to the 1970s to find a similar episode.

The average Australian household is under acute and increasing pressure. Consumer spending is falling, as are household savings. The private sector has essentially stalled. It’s only government spending – federal government spending is at record levels – that is keeping the economy (barely) afloat.

The major banks are reporting rising levels of mortgage stress, which points to a significant and unpleasant implication of what’s developed within the economy.

Relatively high interest rates are a bonus for those with significant savings and no debt. Sharemarkets have, despite the gyrations over the past week or so, boomed this year. Those with high incomes or big fortunes have a very rewarding post-pandemic experience.

The little over a third of households with mortgages, which tend to be younger, sub-55-year-olds, or those who rent, are doing it a lot tougher amid relatively high interest rates and a surge in the cost of living.

If wealth inequality was a topic of conversation before the pandemic, it is a much more significant one today.

The RBA has a dilemma. The data says the economy is close to tipping into recession, and that real and growing financial stress is developing in the more vulnerable households, but inflation remains too high, and the full impact of the federal government tax cuts on demand and inflation has yet to be felt.

The unemployment rate may have edged up, but is still at levels quite low by historical levels and quite inconsistent with what would be expected if the economy was about to fall over.

The risk of starting to cut rates too soon is that they could reignite the inflation rate. Cut them too late and the bank could induce a hard landing – a painful recession – for the economy.

How did we get to this position, and why is the Australian experience different to that of some of the other advanced economies, most notably the US economy?

The inflation breakout was triggered by the supply chain shocks caused by the pandemic.

In response to the pandemic lockdowns, governments threw unprecedented amounts of cash at businesses and households. Supplies of goods and services were severely constrained but demand, given that many households were suddenly flush with cash, surged – as did inflation.

The supply-side influence on inflation rates waned as supply chains were restored. While some have been re-engineered, thanks to trade wars and the pandemic’s encouragement of “re-shoring” and “friend-shoring” of essential activities, they are now functioning normally.

In most of the advanced economies, however, services inflation has been stickier and remains elevated. Higher wage growth in tight labour markets to compensate for the higher cost of goods and services, soaring insurance costs, higher health and education costs, and the big spikes in rents are a feature of most advanced economies.

In Australia, labour cost increases, while slowing, may have been exacerbated by the federal government’s “reforms” at the start of its current term.

In the US, services inflation remains elevated but has been offset by a productivity and investment boom, which is probably a function of both the greater dynamism and flexibility within the US economy but also the massive amounts of infrastructure and investment spending the Biden administration has presided over. There’s a heavy technology dimension to the improvements in US productivity rates.

Here, the picture is quite different. Productivity has, as Jim Chalmers has noted, been a long-standing problem – one that successive governments in recent decades have done little, if anything, to address. It is, however, getting worse, with the June quarter showing another 0.8 per cent decline.

The numbers seem to signal that, even as demand within the economy has softened, the ability to supply that demand has diminished even more – hence the stubbornness of the inflation rate. Unit labour costs have risen, as have the hours worked, but output has declined.

It’s that gap between the level of demand within the economy and the economy’s capacity to meet it that the RBA is trying to close. Given how singular and crude the cash rate is as the bank’s primary monetary policy lever, that can only happen by smashing demand, which generally means rising unemployment and household distress.

More government spending might blunt the pain, but it wouldn’t address the ailment. What’s required is productivity-enhancing micro-economic reforms. Business calls for less regulation and faster approvals for new investments might help, but there is a larger and more complex national conversation that should be had as a matter of urgency.

In the past, our resources sector has helped bail us out in times of economic stress. But the sector is heavily reliant on China, and given its faltering economy, it’s unlikely we’ll see another commodities boom in the near term.

It’s easy to point the finger at the RBA, as Chalmers has done, and blame it for the country’s economic weakness and financial pain, but it is responding to a problem that is not of its making, and one it has neither the responsibility nor capacity to solve.

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