Steady lowering of interest rates can only end negatively

The case for a more aggressive fiscal policy to end the present stagnancy is gaining ground.

The RBA remains confident, and has other tools to try to pump economic growth. Picture: AAP

“In a way it’s a last desperate gamble … more of the same. And they just hope that it might work,” says William White, former chief ­econ­omist at the Bank for International Settlements in Switzerland and deputy governor of the Bank of Canada.

“We’ve been in a currency war for about a decade,” he says, talking about central banks’ tit for tat cuts in interest rates that have finally pushed the Reserve Bank of Australia over the edge.

For 32 months, governor Philip Lowe had held the line, keeping the cash rate at 1.5 per cent. Since June it has halved, dropping to 0.75 per cent on Tuesday, a historic low signalling an aggressive push by the RBA to cut the jobless rate, boost anaemic consumption — and keep up with the Joneses.

“If the big guys are going lower, the little guys are along for the ride,” White explains, sympathising with the RBA’s move, which drew condemnation from former treasurer Peter Costello and high-profile former board member Warwick McKibbin. Even former RBA governor Ian Macfarlane says he’s uneasy.

The framework that has governed monetary policy since the early 1990s — independently set a short-term interest rate to control domestic inflation and growth — has lost a lot of paint since the ­financial crisis. Inflation has collapsed despite repeated cuts to ­official interest rates.

“All the central banks want to give the message that they are masters of their own destiny but the honest truth is everyone knows if they step out of the track established by the Fed (US Federal Reserve) and the ECB (European Central Bank), the currency will blow up in their face,” White says, recalling his own difficulty in the 80s trying to lower Canadian ­interest rates.

On one level, it’s hard to see what all the fuss is about. Unemployment in the major economies, including Australia, is low. Wage growth is picking up. House prices appear to be roaring back in Sydney and Melbourne.

“So why the concern?” Lowe asked in a speech last week paving the way for this week’s cut. “The answer is the ­increased downside risks gen­erated by various geopolitical ­developments.”

The escalating US-China trade war has throttled international trade growth, causing central banks in Europe and the US to dramatically reverse course. The US Federal Reserve cut its official ­interest rates last month — egged on by a highly critical US President — to a range of 1.75 to 2 per cent, with another cut expected ­almost certainly this year and four pencilled in for next. The ECB, the other monetary behemoth, trimmed its rate to -0.5 per cent and is a month away from buying €20bn ($32.5bn) of government bonds a month with newly created electronic money — a form of quantitative easing.

Earlier indications that interest rates, after a decade near zero, were heading back to normal ­levels have collapsed as fast as governments’ borrowing costs. The yield on the Australian government 10-year bond, its most common way of borrowing money, has fallen below 1 per cent for the first time.

A day after the RBA cut the ­official cash rate, rattled investors dumped their shares after a key index of US manufacturers fell for the second month in a row in September, hitting a 10-year low. “It was akin to waking up to the smell of smoke and wondering if the house had caught fire,” IG Markets analyst Kyle Rodda says. Since the US entered its longest period of economic expansion in July, every blip in the US data has been taken as a harbinger of recession.

Local blue chip shares finished the week down almost 3 per cent, an almost $80bn hit, while the Australian dollar dropped to a new 10-year low below US67c.

What this dramatic loosening of monetary policy means for the Australian economy won’t be clear for at least six months, given the lags between interest rate cuts and their effects.

In the meantime, policymakers will be hoping it works. Economic growth fell to 1.4 per cent in June, far short of the government’s and Reserve Bank’s forecasts. Despite strong jobs growth, household consumption hasn’t increased in the past year and wage growth, while modestly stronger, remains a shadow of its former self.

Discretionary spending growth has slowed to a trickle. Car sales, a barometer of consumer confidence, dropped 5.1 per cent in the year to June, the biggest ­annual decline since 2011. The jobless rate rose a little to 5.3 per cent in August, a worrying sign given the RBA’s goal is 4.5 per cent.

Despite back-to-back interest rate cuts in June and July, annual housing credit growth fell to 3.1 per cent in August, the lowest since the RBA began keeping records in the 70s. And the bounce in house ­prices, while promising for homeowners and property investors, is based on the lowest turnover in stock in 30 years — below 4 per cent a year (at an annualised rate).

Job growth has been the silver lining, at 2.5 per cent a year, well exceeding forecasts. But the public sector has been doing the heavy lifting, suggesting an eventual drag on productivity.

About 97 per cent of net jobs growth in the past year has been in the public sector, according to ANZ economist Catherine Birch. “Relying on the public sector to create employment is not sustainable,” she says.

Hopes the Coalition’s tax rebates, worth $8bn to households in the second half of the year, will come to the rescue are fading. Retail sales improved in August, rising 0.4 per cent since July, but economists fear it’s not large enough. “The fact that retail sales growth did not surge in August suggests that those tax cuts are not being spent,” Capital Economics’ Ben Udy says.

White, for a decade to last year the chairman of the OECD’s economic and development review committee, is sceptical that lower rates will have much effect. “The more you cut rates, the less willing people are to respond. At certain point the debt levels are so high that the game stops,” he says. Central banks are “doubling down” on a “debt trap”, he diag­noses: lower rates encourage taking on more debt, while higher rates precipitate the crisis they are trying to avoid.

“Central banks have been using easy money for such a long period of time, they can hardly now say, ‘Oops we made a mistake’, and the unintended consequences are doing more harm than lower rates are doing good,” White says.

“Business cycles don’t last forever, unless you’re Australia, where they’re in year 27,” Federal Reserve chairman Jerome Powell observed in November last year. Perhaps Powell had read The Economist’s effusive account a few months earlier.

“Australia has been growing for 27 years without a recession — a record for a developed country. Its cumulative growth over that period is almost three times what Germany has managed,” it gushed.

The problem is income per capita in Germany overtook Australia’s in 2014 and has powered ahead since. “Catch up in income per capita relative to the upper half of OECD countries has paused since 2011, as growth has lagged, affected by lower commodity ­prices and ­reduced resource-sector investments,” the OECD said last month. Incomes per person matter for living standards.

Whatever the economic outlook, some are tiring of the sunny refrain, beloved of whichever politicians are in government, that “we” have enjoyed 28 years of ­“uninterrupted growth”.

Wilson Sy, of Investment Analytics Research, says high immigration and booming exports to China have hid the economy’s weaknesses. “Strong immigration growth without commensurate growth in infrastructure has led to an ­unmeasured fall in the real standard of living,” says Sy, a former senior researcher at the Australian Prudential Regulation Authority. Despite talk of slowing immigration, population growth remains 1.6 per cent, the highest in the developed world, the bulk of it made up of immigration.

The Reserve Bank remains confident; it has other tools to try to pump growth. While the headlines this week screamed “one step away from quantitative easing” — creating money to buy bonds — it’s almost certainly two steps: the bank could trim to 0.5 or perhaps even 0.25 per cent before embarking on a bond-buying spree. The RBA’s own internal model calls for a negative cash rate, Goldman Sachs economist Andrew Boak says. “Strikingly, the model suggests the RBA would need a -1 per cent cash rate if it wanted to achieve its unemployment and inflation goals,” he says. “Assuming the RBA refrains from negative rates in practice, an equivalent amount of stimulus could be ­delivered by lowering rates to zero and implementing a QE program worth around $200bn.”

Pulling out all stops to keep the currency weak might help bolster growth in the short term. Longer term, a stronger country might be a better aspiration.

“Who would you rather be, Switzerland or Argentina?” White asks, recalling the Swiss franc was about eight to the US dollar after World War II and now it’s closer to one. “That’s forced the Swiss to be more productive and shift into higher quality manufactures.”

It will be an odd situation if this is where the RBA ends up, furiously pumping the economy with new money while the government in Canberra proclaims a budget surplus. Putting the budget back in the black has been the bedrock of the federal government’s economic sales pitch. It may have to ditch it if an imminent housing revival isn’t enough to convince households to spend. At least its efforts so far won’t have been in vain.

“There’s growing recognition that we will need to use fiscal policy more aggressively in the next downturn … and Australia is very well placed to deal with that,” White says.