Thursday, October 15, 2009

BIS says rate increases a mistake

Chief economist for BIS Schrapnel, Frank Gelber, thinks the Reserve Bank has increased interest rates too soon. Glenn Stevens was as nervous as all hell about a cash rate at 3 per cent but rates in most other economies are going to be stagnant and hovering at less than 1 per cent for some time to come. Although a significant contributing factor, the Aussie dollar was rising independent of interst rates. Further increases in the dollar's value is going to have an real impact on a range of sectors beyond commodity exports.

Here is Gelber's argument;

We all know that interest rates have to rise, and rise substantially, at some stage. These are emergency rates resulting from the global financial crisis and intended to prevent recession.
Australian rates aren't nearly as low as overseas rates. Mind you, most of the Western world really needs low rates. They face severe recession. To turn around the old saying, America has a bad flu but we're only sneezing. The US, Britain and parts of Europe are experiencing financial crisis but we're experiencing a credit and equity squeeze.

I thought the rate rises would start later. But now that they have begun, the question is not so much how many more rises are to come, but when. One, or even several, rate rises won't be fatal. The damage would come from a series of aggressive rate rises, stifling recovery.
And there is still time for the Reserve Bank to postpone further interest rate rises until the economy does strengthen. By the end of the tightening process, cash rates will go back to a neutral rate of about 5.5 per cent. Indeed, we think they'll overshoot and end up at about 6.5 per cent. But we think that will be in 2012 when the economy is strong.

Timing will be important. As always, for the RBA it's a balancing act. The trick is to tighten from the current unsustainably low levels without damaging economic recovery.
Why did they raise rates so early? What are they trying to achieve? I hate trying to second-guess the RBA's logic, but this is important. The RBA obviously thinks the economy is a lot stronger than we do. Even in these more open and enlightened times, RBA statements tend to be vague, and open to several, often contradictory, interpretations.

Having said that, they seem to think that investment is recovering. It's not. The capital expenditure figures were boosted by the tax concessions on equipment investment. And government building and infrastructure spending, though strong, won't be enough to offset the prospective collapse of business investment.

The construction sector's direct and indirect contribution of about minus 2.5 per cent this financial year, won't be as bad as the negative 4.7 per cent that caused the downturn in 2001. But the shock will be hard to withstand. Worse, not only will investment decline this financial year, but it will happen when household disposable income is weak. Business profits have started to fall. The sector is just emerging from a credit squeeze and, when finance is available, companies face high interest rates. So business is in cost-cutting and cash preservation mode, curtailing unnecessary investment.

Meanwhile, sluggish wages and employment growth means that household disposable income is weak, indeed negative in real terms, and that will constrain spending. Rising interest rates will further weaken household incomes. The run of good data will end. There will be some pretty weak readings towards year end as government stimulus recedes. The data will weaken with the economy. And confidence will sag with the data.

Confidence can't be sustained under its own steam. It's strong now with the improvement in the economic indicators and less fear of unemployment. But the world isn't a series of indicators in isolation. When news on the weaker economy comes through, the indicators will deteriorate and confidence will weaken.

Having said that, a few interest rate rises won't do a lot of damage. And just as well.
In this environment, households are tending to absorb much of the stimulatory effect of last year's interest rate declines by maintaining their mortgage payments, thereby reducing debt more quickly.

The other side of the coin is that this gives them more leeway to maintain (and not increase) payments in the face of rising interest rates, thereby cushioning the impact on spending. The cohorts most affected are recent housing buyers who stretched to finance large mortgages.
But it's bad for the dollar and competitiveness. And that's contractionary. Australia is tightening before other Western countries, raising the interest rate differential and boosting the Australian dollar.

That's a disaster for what's left of the domestically produced tradables industries -- in particular manufacturing, tourism and education for overseas students. And, while primary production and Chinese demand remain strong, the higher dollar hurts prices received for agricultural and minerals commodities. With weak investment, weak household disposable income and an overvalued dollar, I wouldn't be surprised to see a negative September or December quarter gross domestic product result.

Only housing is picking up. But we need the housing recovery to drive growth. And we need the housing. The rate rise will reduce household disposable income and therefore expenditure and reduce the affordability and hence demand for residential property. Maybe the RBA is trying to dampen the aggressiveness of housing owner-occupiers and investors so that there is less damage as interest rates do rise.

Meanwhile, there is no hurry to raise interest rates. With overseas rates likely to remain low, the resultant strong dollar will dampen already weak growth and perhaps cause structural damage to the remains of our tradables industries. I would have waited until well into next year.


Bromoney said...

I didn't even realize they raised rates.

Paul Cunningham said...

Bromoney: Thanks for your comment. Yes, Australia put its rates up last week. We're the first G20 nation to do so. Other countries are getting ready to do the same. Except, I would say, the Euro nations, Japan and of course, the US.

This will see the US dollar loose further value which, in the longer term, will be good for a US recovery which will be good for all of us.

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