Slashing rates could prevent an economic disaster

Slashing rates could prevent an economic disaster
Cassidy KnowltonJuly 17, 2011

A few months ago I started a public awareness campaign, which we called "The RBA Appeal", in an attempt to draw the RBA’s attention to the underlying softness in the Australian economy, which could be exacerbated by risks offshore.

It appears that the economists are starting to listen: Westpac’s Bill Evans has done a 180-degree turn from predicting rate hikes to now forecasting four rate cuts.

When you accept the historically low consumer and business confidence estimates reported by the Westpac-Melbourne Institute and NAB surveys, the dismal performance of retailers like David Jones, the striking decline in employment growth, the slide in house prices, and the relentless downgrades of economic growth forecasts from various bank economists, you start to appreciate the pain that pervades the real economy, not the “official” economy that the Reserve Bank theorises about.

The Reserve Bank tells us that wages are growing, which is one rationale for a cycle of rate rises. However, these figures mean little in the suburbs, where the only thing growing is electricity charges, grocery bills, fuel prices and flood levies. Meanwhile, waiting in the shadows is a carbon tax that no one understands except for the fact that it’s another hand in their pockets.

Several weeks ago, I observed that even though the Reserve Bank had raised interest rates seven times in 18 months – and seemed committed to more rate hikes – the bond futures market, which tends to lead equities, was pricing in a full rate cut by January 2012.

I assumed this indicated the Reserve Bank would be pushed to change course by a sudden “sovereign event”, such as a government going broke, defaulting on its debts, or behaving in a way that moves markets, like declaring war.

What a difference two weeks can make: Greece and Italy are now clear contenders for a default-and-bailout scenario that will hit the global credit markets harder than the Lehman Brothers collapse in 2008.

When Lehman Brothers – Wall Street’s fourth-largest investment bank – sought bankruptcy in September 2008, Barclays and Nomura bought out its books. It was as orderly as could be expected, yet it still triggered the global financial crisis.

If a western European nation goes bust, the shock waves could hit Australia much harder; we’ll see credit freezes, lenders going out of business, and a bear market that could take years to recover. The mining industry might sail through untouched, but it only employs 2% of our workers. The other 98% of employers, and small business in particular, will bear the brunt of the turmoil.

The United States is caught in its own sovereign event: a president who wants to raise the national debt ceiling to honour its borrowings, and a Congress that wants to cut government spending to remain beneath the debt ceiling.

And while the fears of a sovereign event create the headlines, there are deeper structural problems in Australia that have already sapped confidence.

One is the “two-speed economy”. It has become fashionable for economists and media commentators to scoff at this idea, but when the derision ends the question remains: how do you judge an entire economy on the extraordinary success of the narrow mining industry? Bloomberg News put it most succinctly a few months ago when it found a 24-year-old mining rigger in Western Australia earning more than the chairman of the Federal Reserve, Ben Bernanke.

A second issue is that Australia is supposed to run on monetary policy where the cost of money controls inflation. But governments still have fiscal programs, such as the first-home owner grants and the Building the Education Revolution scheme. These are inflationary because they pump cash into the system, which the Reserve Bank has to control with rate rises. Our current rate rise cycle started as the Rudd government’s fiscal stimulus package kicked in.

The problem is that the Reserve doesn’t have the capacity to respond to – or ignore – specific causes of inflation. It can’t differentiate between wages growth in industries, or between sources of fiscal stimulus; it can only raise, lower or hold interest rates based on official inflation indices.

But that doesn’t help hardworking Australians. I talk to a lot of business owners, and I can’t recall a time when there has been so much confusion. In the early 1990s, when unemployment was high and banks wouldn’t lend to small businesses, the landscape was very clear. The pain was spread evenly.

Today, business owners are confused: how can interest rates be rising when the economy they operate in is so flat?

Unlike the low-confidence environment of the early 1990s, we’re not worrying about unemployment this time. However, the Reserve Bank should note that the quantitative driver of employment in this country is small and medium-sized businesses, not the mining industry’s wages, which only accrue to those in that industry. The Reserve Bank should remember that most businesses in this country are “mum and dad” affairs, whose business finance is raised off their family mortgages. They are highly sensitive to interest rate movements, and so are their hiring intentions.

With the financial year having ended, the Reserve Bank has an opportunity to take its head out of the technical economy and look at the practical economy. At a time when households and small businesses are low on confidence and high on costs of living, we should be easing interest rates to secure a soft landing from the expected global problems, and to guide the domestic economy back on to a sure footing.

I am glad Westpac has finally bought into my arguments. But rather than cutting rates once this year, and three times next year, as Westpac forecasts, why not get pre-emptive? If the Reserve Bank cuts rates at the next board meeting, it may avoid the need to have to slash rates in a GFC-style fashion after the crisis has already hit our shores.

People like to say the Reserve Bank gets ahead of the curve. They forget, however, that our Reserve Bank kept mortgage rates at 9.6% as late as August 2008, and only reduced rates for the first time in September that year. The RBA got behind the eight ball in the last crisis. I would hate to see history repeat itself.

Mark Bouris is the chairman/co-founder of Yellow Brick Road Group.

This article originally appeared on Business Spectator.

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