Q3 Outlook: Monetary madness in the ‘miracle’ economy

With the global economic outlook weakening and the Australian economy losing momentum, the Reserve Bank of Australia already in June began what is likely to be a series of cuts to its cash rate, which will probably land at 0.5% next year or even by year-end. Easier monetary policy will be required to deal with labour-market slack, weakness in the housing sector and falling consumption. 

Faced with a tumultuous political environment, Brexit woes, trade tensions, new battle lines on the front of global technology dominance and a slowing Chinese economy, businesses around the world are losing confidence, and global growth is ailing. This is apparent particularly when viewed through the prism of trade and manufacturing. The uncertainty paralyses decision-making at multinational companies, burdens capex intentions and forces supply chains to be unravelled to reduce risk as businesses are unsure of the regime under which they will operate in the coming years. 

Against this backdrop, US Federal Reserve chief Jerome Powell, no longer set to wean stocks of their addiction to easy monetary policy, has surrendered for a second time in a bid to bolster confidence. And the question is no longer if the Fed is prepared to act, but rather by how much. So a domino effect is in motion. As the global outlook weakens, central banks are faltering in their resolve. Both the Fed and the European Central Bank, which not long ago talked of raising rates, are now ready and willing to race to rock bottom. The Reserve Bank of Australia has already begun to tread down this treacherous path, having delivered in June the first in what will be a series of cuts to the cash rate, which is likely to land at 0.5% in 2020. The risk to this view is to the downside, and the cash rate could reach that level by year-end.

Australia’s near 30-year recession-free run, the envy of central bankers around the globe, is now at risk as economic malaise grips. The “wonder, down under” that escaped zero interest-rate policy, negative interest-rate policy and quantitative easing has not managed to vanquish the business cycle and will not be so lucky this time around. 

In Australia, easier monetary policy will be required given the sizeable spare capacity remaining in the economy which continues to lose momentum and is running well below potential. The weakness is likely to lead to a further rise in unemployment and persistent disinflationary pressures, even before a potential global shock appears. Remember, trade is just a sideshow for the unfolding rivalry between the 20th century’s superpower and the would-be hegemon of the 21st century’s bid for supremacy. And, while a trade deal could still be reached with China, Europe could easily be next in the firing line. But perhaps the main unknown here is US President Donald Trump’s calculation of what will score points with his voters, which could turn on a dime. 

Australia’s March quarter national accounts confirmed that the slowdown seen in the second half of 2018 has extended into 2019, with weakness in the housing sector and falling consumption key concerns. Labour-market slack, as measured by both unemployment and underemployment, needs to fall substantially before wages can rise. This significant spare capacity in the job market will be a major impediment before stagnating real wages reverse their course and relieve the pressure on debt-laden households. That would be critical for an economy where household consumption accounts for almost 60% of GDP. The RBA is communicating that unemployment now needs to fall below 4.5%, and even lower if overseas experience is anything to go by, before inflation would pick up. So, there is significant work to be done with unemployment currently sitting at 5.2%, well above the full-employment level needed to spur wage gains and inflationary pressures.

Combine stagnant wage growth, labour-market slack and an economy heavily reliant on private consumption, and you have an ugly cocktail for sub-trend economic growth. With the case to cut rates having been made, why wait? The RBA has materially shifted its assessment of the labour market and the degree of spare capacity that remains, so there is little to gain from holding off until August. So, next up is the bank’s July meeting, and one more cut is likely by November. The RBA has few options, especially considering the limited scope for banks to pass on further rate cuts as the official cash rate creeps towards the zero lower bound. Furthermore, the prospect that the Fed will cut rates goes against what the RBA has identified as a critical policy lever to stimulate the economy: the exchange rate. So, get ready for lower yields.

After three cuts by November, the RBA is likely to pause to assess the outlook, while remaining locked and loaded if conditions warrant further action. A fourth rate cut in play for 2020 would take the cash rate down to 0.5% which is likely the effective lower bound. One problem is that the RBA is up against the law of diminishing marginal returns in terms of policy stimulus. Don’t forget that in the previous four cutting cycles the RBA delivered an average of 300 basis points of easing. But, as Steen Jakobsen points out in his introduction to this outlook, the cost of capital is just one small piece of the puzzle, and, with interest rates already at historic lows, arguably not the main factor hindering economic growth. 

In the current low-rate environment and for the foreseeable future, fiscal policy therefore has a far more active role to play. So, what is the bigger problem? Governments shirking their responsibilities to focus on infighting instead of policy reform. Monetary stimulus is ineffective for the challenges we face, and bureaucrats in Canberra must have realistic expectations about what central banks can achieve to stimulate the economy. Monetary policy will never replace sound economic policy. So, rather than relying on central bankers to clean up the mess, the government must deliver productivity-enhancing reforms, infrastructure spending and other fiscal measures to restore confidence and start a self-sustaining recovery in economic growth. It needs to do that while expanding the productive capacity and potential output of the Australian economy — something the RBA has long bemoaned, and now more vocally than ever. But the newly elected treasurer Josh Frydenberg seems completely unperturbed by these challenges, and instead is determined to retain political capital and become the first treasurer to deliver a surplus in over a decade. Unfortunately, if the current slowdown persists and the credit impulse is right in indicating the economic low point remains ahead, Frydenberg may have no choice. After all, the credit cycle leads the economic cycle.

Where there is a policy power vacuum, the RBA must be ready to step in and do the heavy lifting in case of an enduring threat to growth and employment. Although the RBA hopes it will not need to resort to unorthodox measures, once the conventional policy toolkit has been exhausted (which is already close), the RBA would probably turn to quantitative easing if the economic outlook were to deteriorate further. Asset purchase programmes could take several forms, depending on the objective. Or, given that the RBA has a last-mover advantage, it could skip ineffective QE and retool asset purchases to go straight to “helicopter money” or infrastructure spending, in keeping with the global fiscal panic. However, such a move would likely require an economic crisis to unfold.