The February employment report that revealed 71,000 jobs had been created effectively sidelined any immediate prospects for further official interest rate cuts.
Market participants responded to the number by ruling out any more cuts in the next 90 days, which takes us to the middle of the year. The Reserve Bank of Australia has lowered rates by 175 basis points since November 2011 and now is playing a wait-and-see game. There is a very strong case, however, as to why the Reserve should cut rates by another 25 basis points or possibly half a per cent by the end of winter.
Here is a list of arguments.
1. The lead indicators in any economic recovery are housing finance and retail sales. Both of these critical numbers have improved in recent times but nowhere near the rate of previous cycles in the early 1990s, and after the implementation of the GST.
The most recent evidence of this modest recovery can be seen in the sales numbers reported by the discretionary retailers around the country. Investors have got excited by the profit numbers and have been buying shares, but the reality is most of the earnings lift has come from recent cost-cutting rather than sales growth. This dynamic has a limited shelf life.
2. The latest figures by the Housing Industry Association trumpeted that housing affordability in Australia improved during the December quarter and was now the best it has been since 2009. This is cold comfort, though. Housing affordability is only approaching the longer-term average and is not cheap. Australians are still spending about 30 per cent of their disposable incomes on home loans in what remains one of the most expensive housing markets in the world. The last time Australia’s housing market entered a sustained rise, in the 1990s, it did so at much lower price points.
There are only three ways to make houses more affordable – a drop in price, a boost to wages or interest rate cuts. The most sensible of these three now would be lower rates.
3. Consumers are still not in a mood to borrow. The savings rate remains above 10 per cent of incomes and rightly so, with average debt levels hovering at a concerning 150 per cent of household income. While this number has stabilised in recent times, it is not falling. Consumers need as much help as they can find.
4. The Reserve does not have as much control over the Australian dollar as it would like but this does not mean it should walk away from the issue. The strong local currency makes many industries in Australia uncompetitive and effectively acts as another form of monetary tightening. A reduction in interest rates can do nothing but help the dollar. Its impact could increase if the US economy is able to strengthen this year.
5. The growing chances of a change in federal government at the election in September should mean tighter fiscal policy into next year. This will act as a handbrake on the economy and keep the dollar strong. To offset this constraint, the economy will need lower interest rates.
6. Trying to second-guess the peak in the mining capital expenditure boom can be tricky, but this much we do know. Between now and 2016 the expansions in iron ore, coal and LNG production will decline, with some even labelling it a spending cliff. During this year mining capital expenditure accounted for between 50 and 60 per cent of gross domestic product growth. As this contribution subsides, the domestic industrial economy needs to pick up the slack. It makes sense to move early rather than too late.
7. Corporate Australia has been slower to cut capacity and costs than formula one driver Mark Webber to leave the grid at the start of a race. For whatever reason, many sectors in corporate Australia have held out for a pick-up in demand to alleviate pallid earnings. This has failed to eventuate and a range of sectors such as retail, transport and banks are only now addressing their margins in a lower-growth environment.
Corporate spending is usually the last cab off the rank in an economic pick-up, but this time they are unusually slow, as evidenced by ongoing falling capacity utilisation measured by NAB. Many companies are reporting acceleration in cost-cutting since Christmas, which means that a pick-up in capital spending outside mining is still some way off.
8. Unemployment levels remain low at 5.4 per cent, but hours worked by Australians have declined over the past year. Underemployment remains elevated.
9. Given the prevailing economic evidence, it would seem one or possibly two 25-basis-point cuts would suffice to address many of the concerns in the previous points. To go lower than an official rate of 2.5 per cent would be dangerous, given it means we may have negative real interest rates (below the inflation level), which invariably ends up with a poor outcome.