Economic and Financial Market Update: How Long Must We Sing This Song

Summary:

• The RBA today cut rates by a quarter percentage point to 1%;

• If the unemployment rate rises further another cut is likely;

• Financial markets currently expect another quarter percentage point rate reduction before year-end;

• Monetary policy doesn’t work as well as it used to;

• Fiscal policy will need to do more.

‘I can’t believe the news today

I can’t close my eyes and make it go away’

‘Sunday, Bloody Sunday ‘

U2

At least in my view bands just do not get bigger (or better) than U2. Into the Rock and Roll Hall of Fame in their first year of eligibility, U2 has won more Grammy awards than any other artist. For some reason, Rolling Stone magazine only ranked U2 number 22 in its 100 Greatest Artists of All Time (admittedly their suggested number one, the Beatles, wrote a decent tune). From that record it is obvious U2 recorded plenty of good songs on plenty of good records. I find it hard to pick my favourite, although few surpassed ‘Sunday, Bloody Sunday’ in raw rock energy. About the ‘Troubles’ in Northern Ireland, the song was one that U2 performed particularly well (and often) live.

Unlike the song, the news today though was perfectly believable. For some time financial markets have been speculating that the RBA will have to cut the cash rate by at least half a percentage point this year. June was the first instalment, and there was growing speculation that July would be the second. In that respect mission accomplished. The RBA justified the cut as boosting the confidence that its forecasts (falling unemployment rate, rising inflation and GDP) will be met. But since the RBA last met the domestic GDP numbers were weak, and the global economic data has been soft. Firms and consumers report muted price pressures. The case for a rate cut was pretty clear.

It is not all bad news. Infrastructure spending is strong. There is plenty of Government spending on health and the NDIS. High commodity prices has led to miners increasing their capex spending. The worst of the house price decline is probably in the rear-view mirror. And the lower $A is a plus. Nonetheless, the RBA made it clear in its accompanying statement that if the jobs market does not improve further rate cuts are likely.

Will lower rates help the economy?

But what is less believable is when you stand back and looking at the level of the cash rate. One percent! In nominal terms the overnight cash rate is now at record lows (as it is in many countries). True after allowing for inflation the ‘real’ overnight cash rate has been lower (in both the 1970s and 80s but as a result of inflation being unexpectedly high not the RBA deciding that interest rates needed to be very low). You can close your eyes but those low rates won’t go away!

A question I am repeatedly asked is whether reducing interest rates at this level has an economic impact? To use that overworked metaphor, is monetary policy pushing on a piece of string? The short answer is that the string is still moving but not as much as yesteryear. To make an obvious point, cutting the cash rate from 5.5% to 5% has a bigger impact than when it is reduced from 1.5% to 1%. The discussion lists the different ways that a lower cash rate impacts the economy and whether those ways are still working. 

Encourages more borrowing

An obvious way that low interest rates impacts the economy is that it makes it cheaper to borrow. Over the past couple of decades households in particular ramped up their borrowing taking advantage of the trend decline of interest rates. But this channel is not as effective as it once was. 

Mortgage credit growth has slowed the past year as households became more worried about falling house prices and rising indebtedness. There are signs that the worst of the housing decline might be over. One reason is that housing is becoming more affordable. This has enabled first-home buyers to become a bigger part of the market. But investors are unlikely to return in big numbers, at least until there are more signs that house prices have clearly bottomed (ideally increasing). And given the amount of supply still to hit the market a significant rise in prices is unlikely, at least for the next year or two.

In any event, a bigger issue for households is not so much the price of money but its availability. Credit has become tougher to get, although lending standards might be in the process of easing a little. Certainly the process of getting information for a loan should become more efficient over time. But with Australia having amongst the highest household debt ratio in the world the days of very easy mortgage lending standards are over.

Lower interest rates can also tempt firms to borrow more. And with most firms carrying relatively little debt the business sector has the capacity to do so. But the level of interest rates is only one factor that firms think about when deciding whether to borrow. At least as important are firms’ views about business conditions. Right now firms have mixed views about the economic outlook. Business also have a high level of retained earnings (notably miners). All this means that the proportion of companies indicating that they won’t borrow remains high. For smaller firms there is also anecdotal evidence that some are struggling to access credit as a result of the tightening of mortgage credit standards. 

Incentive to reduce saving

Lower interest rates reduces the returns on saving, making consumption a more attractive option. The household saving ratio has declined over recent years. Lower rates might have been a factor. But a bigger reason is that as disposable income growth has been modest over recent years households have less spare cash to put away for a rainy day. One indication that interest rates are not the driving influence on saving decisions is that households indicate that deposits remain an attractive form of saving. Deposits as a proportion of household financial wealth (ie, shares, super) has been broadly flat over recent years. And household deposits picked up the last time the cash rate was being cut (2015 and 2016). 

Business saving is net operating revenue minus interest payments, dividends and taxes. It is broadly equivalent to retained earnings. Relatively strong profit growth (notably for miners) has enabled both the dividend payout ratio and retained earnings to be at a relatively high level. Conceptually low interest rates should encourage firms to reduce their level of saving given how cheap it is to borrow additional funds (and encourage shareholders to ask for bigger dividends). That retained earnings is quite high suggests firms still have some confidence about the outlook (notably miners). It could also means that post-GFC firms have wanted to reduce their reliance on external financing

Improves cash flows

Lower interest rates reduces payments on existing debt, improving household and business cash flows. This is clearly benefitting firms, with the proportion of operating profits allocated to interest payments at record lows. This has helped firms boost dividends, buildup retained earnings and keep corporate bankruptcies low. With households the cash flow impact of lower interest rates is more complicated. Borrowers benefit from lower mortgage payments but savers suffer from lower deposit rates. Because in aggregate households pay more in interest than they receive lower interest rates overall benefits consumers.

But this cash flow benefit to households may not necessarily lead to more spending in the economy. Many households don’t change the size of their mortgage payment as interest rates go down. Currently a high proportion of households are indicating that paying down debt is a good use for any spare dollars. So a lower mortgage rate enables households to pay back their home loan quicker. It also provides those households with a repayment buffer in the event of unemployment. So the cash flow benefit of lower interest rates for households might not significantly boost current economic growth. But it can help boost future spending in the economy (because households will have less debt in the future). And it will reduce problems in the event of an economic downturn.

Boosts asset prices

A lower cash rate can boost asset prices (eg, equities, residential and commercial property), although more important for most asset prices is the change in long-dated interest rates. Higher asset prices boosts wealth. And wealthier householders tend to spend more. Rising asset prices also means households and firms have more collateral against which they can borrow. But the effectiveness of this channel has been mixed. Bond yields (such as the interest rates that the federal government or large companies pay) have declined. Lower bond yields have helped drive commercial property prices higher. But the equity market earning yield (the inverse of the price-earnings ratio) has not declined significantly despite the large fall of interest rates.

RBA research has found that the single biggest driver of house prices over time has been the fall in mortgage rates. This is probably because lower mortgage rates increases the amount that householders can borrow (and therefore they pay more for a house). But the tighter lending criteria, excess supply of housing and already high level of debt will limit the amount that households can (and want) to borrow. But lower rates has helped stabilize housing prices.

Lowers the exchange rate

An important channel for monetary policy is that lower interest rates can result in a weaker $A (as it reduces returns in Australia relative to overseas). But it is the movement in relative interest rates that matters for the exchange rate, not just changes in Australian interest rates. Currently Australian interest rates are low relative to those of major trading partners. For example, Australian two-year interest rates are at their lowest level relative to the US in around 20 years. And relative to Japan they are at their lowest in at least 40 years. But for the $A to depreciate even further will require Australian interest rates to fall by more than global rates. That might be hard to achieve (unless there is a serious global downturn). The other factors that influence the $A (such as commodity prices and the current account deficit) suggest that the $A should be above 70c.

Can interest rates get too low, where the negatives of having very low rates outweighs the positives? The experience of Japan is that an extended period of interest rates being at (or below) zero makes it very difficult to have a profitable banking system (reducing the amount of lending to the economy). This is one reason the US and the UK did not reduce their overnight rates to zero. Also, negative interest rates provides incentives for households to keep their saving in cash as opposed to earning a negative deposit rate in the bank. 

The bigger picture is that right now the issue with the Australian economy is not so much the level of interest rates but a lack of demand. The high level of household debt is limiting the benefits of low rates for consumers. And economic uncertainty means that businesses are reluctant to spend big. Governments have the ability to spend more money. And the very low level of interest rates means it is affordable for them to do so. The forthcoming income tax cuts will be a good start. But more action from the government is likely to be required to get the economy moving back towards cruising speed.

In ‘Sunday, Bloody Sunday’, U2 ask ‘How long must we sing this song?’. For economists and financial markets, how long must we marvel at the current very low level of interest rates is the great question of our times.

We really do live in interesting times.

Peter Munckton - Chief Economist