Thursday, 3 November 2011

Rates cut help avoid recession, not cause it

A couple of intrepid economists who flatteringly dissect my words and forecasts as much if not more than they do the RBA, have queried my forecast for a 3.5% cash rate for the middle of 2012. They suggest the forecast is based on a view that the domestic economy is heading for recession.

ICAP's resident soothsayer Adam Carr suggests to me that "in your own view, Australia is in a recession and the globe on cusp of a depression. Austerity not appropriate here". No Adam - don't think I've ever said that, nor that fiscal austerity is not appropriate. It's the opposite.

The "pungently accurate" Christopher Joye tag teamed Adam with a suggestion that "Koukoulas thinks Gillard/Swan have done a super economic job, but predicts recessionary 3.5% cash rate by June." Well, I have to admit that's mostly true. This Government has done a fine job in economic management. Among other things, fiscal policy is extremely tight which has been one factor in the halving of the inflation rate in the last few years. Partly because of that (plus a few global issues), the RBA this week started a rate cutting cycle and in my view will be cutting rates to around 3.5% by the middle of 2012. That cash rate has nothing to do with recession. (Rate cuts actually work against a recession - lower interest rates actually promote growth!)

A critical point for Adam and Chris, is that any particular cash rate does not indicate Australia is in or near recession. Most adroit economists suggest GDP and unemployment are the indicators of a recession. Weak or falling GDP at the time unemployment rises sharply would be a fair summary of most definitions of recession. Remember that the cash rate is set according to judgments about inflation risks and those inflation risks in turn are derived from assessments of GDP and employment growth, wages, global conditions and critically right now, fiscal policy.

The Carr-Joye error of equating the 3.5% cash forecast with recession overlooks very recent history. In 2007-2008, the Government embarked on perhaps the biggest fiscal stimulus ever seen and at the same time, the RBA slashed rates to a 50 year low of 3.0%. And guess what? No recession. Even a 3.0% cash rate did not equal recession.

As 2011 ends and we look into 2012, the Government is only part way through the biggest fiscal contraction on record and underlying inflation is currently in the bottom half of the RBA's 2 to 3% target range. There are signs that the 4% plus GDP growth rate anticipated for 2012-13 just a few months ago will not be reached, the unemployment rate is ticking up and could get to 5.75%, while wages growth is well behaved and global conditions look horrible on any scale.

In addition, house prices have been falling for a year, share prices have in net terms recorded zero growth this year (and remain 30% down from the pre-GFC peak), credit growth is soggy and housing construction is as weak as water.

The 3.5% cash forecast is based on my central forecasts that GDP growth will be lucky to hit 3% in 2012, unemployment moving to 5.75%-6%, inflation falling to or even below 2% and the global economy sputtering around a 3.5% growth rate rather than the 4% the RBA has reluctantly embraced into today's SMPO.

No recession, no depression. Just moderate growth, very low inflation and an appropriately tight Budget. As a result of these dynamics, lower interest rates ahead.

Enough said.

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