We must be careful not to save ourselves into a recession

I can outline many reasons why I think interest rates should have fallen earlier this year.  These days, one’s reasoning has the most cut through if summed up in pithy quips – “two-speed nation”; “gloom and boom”; “paradox of thrift”; “OK but not happy” or my current favourite, “RVO” – Real Versus Official – economy, that is.

We can now, maybe, even add “GFC Mark 2” into the mix.

But for mine, interest rates are now, ironically, unlikely to fall.  In my opinion we are also unlikely to experience GFC Mark 2.  Remember, the share market isn’t the real economy. Ask yourself, did anything really happen last Thursday to make Apple, America’s most valuable company, worth $36 billion more than the day before?

The US downgrade is as much to do with politics as it is economics.  What we have witnessed (so far) is an overreaction and one which should, in time, correct itself.

There is no doubt that there is way too much debt in the world, that its geopolitical and economic structure is off-balance, and that Western governments continue to spend way beyond their means.  But we, as voters, get the government we deserve.  We demand that the government “spends tomorrow’s today”.  We don’t really want to save for a rainy day.  But gone are the days of “all things cheap”.  Some say we are just starting to enter the “peak of everything”.

Official interest rates, of course, stayed put earlier this month.  But for how long is questionable.  Since the release of the latest Australian inflation figures plus the US government downgrade, things have changed.

For those waiting for interest rates to fall, I now hope that you will be disappointed.  You should now also be careful what you wish for.  A drop in official interest rates would signal that Australia is close to recession.  Ironically, steady interest rates for the time being would do us more good in terms of confidence than a rate drop.  In short, the Reserve Bank is unlikely to cut rates in an environment with such serious market volatility.

So I hope, it is steady as she goes regarding official interest rates for the time being.

You see, and I do hope they are right, the RBA believes that our current economic malaise is only temporary, and that the economic softness (even despite recent events) is not entrenched.  In addition, as the central bank continues to point out, the Chinese economy remains sound – ensuring that commodity prices are healthy and the boost to the terms of trade remains intact.  Let’s hope that the RBA is right in this regard too.

Consumers are not spending out of choice rather than the inability to do so.  We need to be careful that we don’t “save” ourselves into demise – the classic paradox of thrift.

What is missing is a circuit breaker. For mine, that means government elections.

Most economic commentators, however, don’t understand why confidence is so low and hence we are not spending.  Most put forward last November’s rate rise, adverse weather events, weak overseas markets, stagnant job growth, falling house prices and rising household costs, to name just a few.  But very few realise – or are maybe too timid to say – that our overly frugal condition is largely self-inflicted.  We have elected (twice now!) a government that is largely incompetent, is anti-business and has little real interest in the economic wellbeing of the country.

Real inflation of course, not the official CPI measurement, but the increase most of us are paying for the essentials of modern life, is much higher than 3.6%.  Some estimate it is as high as 8.5% per annum at present.

Yes, a lift in official interest rates will have little impact on these rising costs, but we are not, as a nation, prepared to implement the things that would.  We need more tools in our economic tool belt – wholesale tax changes, a moving GST, far less governance, labour productivity reforms, a much higher migration intake, real town planning and most important of all, a long-term view.

A generational outlook is needed and not one based on a three-year election term – or worse still, one centred on the 24-hour media cycle.  But alas, the country isn’t mature enough for such a debate.

Several wise gentlemen, whose economic counsel I seek on occasion, believe that Australia’s cash rate will still rise by between 0.5% and 1.0% within the next 12 months or so.  The recent events will now most likely keep rates steady for the rest of calendar 2011.

So what impact will a 0.5% to 1% lift in the cash rate have on the new housing market?

Some great survey work to this end was recently completed by RBS Morgans.  Its recent survey of the construction industry found that 57% of home builders think that such a lift in interest rates would have a “very material” impact on housing activity. Western Australia and New South Wales, this survey suggests, would be worst hit, with each state scoring a 70% “very material” impact if rates were to rise. Queensland scored 60%, and Victoria just 30%.  Ironically, I believe that Victoria would be the worst hit when interest rates rise.  Watch here, if you are game!

Whilst some builders think that a rise in interest rates “would kill the market,” many of them believe that rate rises are on their way and most home buyers actually expect such.  The key is how much and how well spaced out these rate rises are.  Also, as we discussed in a recent missive, the pending lift in interest rates needs to be communicated clearly and well in advance.

Few of us will like it.  But instead of complaining, or worse still, continuing to argue for an interest rate drop, we should focus our attention on how we will build our businesses in such a climate.  Likewise, what we do regarding our investments.

I don’t have any great pearls of wisdom, but I do believe that in business you should prepare for the worst and hope for the best.  Ensuring cash flow and reducing debt/expenditure also helps.  And when it comes to investing – go long, hold your nerve, buy when the market is low and wait for the upswing.

So in summary, with inflation likely to be above the target range, economic activity uneven and the high level of the currency hurting some industries and regions, the RBA will face difficult decisions during the next couple of years as to what level the cash rate should be.  For now at least, the safest assumption is the RBA will leave the cash rate unchanged for the next three to six months, and then move it higher during 2012.

There is much more behind last week’s London revolt than elitism, corruption and too many social handouts.  For mine it runs much deeper than that.  The London rising (let’s call it that) wouldn’t have occurred if the elites (let’s call them that too) weren’t so corrupt, compromised and incompetent.  The real issue (to paraphrase Stratfor CEO George Friedman) is: who are these people who are running things, what gives them the right to do so, and if that right does not somehow flow from competence, what does it flow from? We have a crisis not of corruption or disjointed wealth, but of sheer incompetence and worst still indifference to that incompetence.  The solution isn’t more regulation but enforcement of the regulations we already have in place.  The world is in need of some serious tough love.  Higher interest rates are just one of many bitter pills we are about to face.