A few excitable, inexperienced and unimaginative people judged the labour force data last week as a reason why the RBA would/should be cautious about cutting interest rates. Recall employment rose by 44,000 and the unemployment rate was steady at 5.2%.
It might be useful to look at RBA policy settings against the unemployment rate over the past decade to see how far behind the curve the RBA risks getting if it doesn’t cut 50 basis points in May and probably more beyond that. The RBA seems to have been wimpish in holding off rate cuts so far in 2012 and here is why.
Let’s go back to the period around 2004 to 2006 to look at why interest rates should be 50 to 75 or even 100 basis points lower than they are now and how a sub-7% mortgage rate is prudent and entirely consist with the recent labour force data.
Before we start, I note the current standard mortgage interest rate is around 7.4% and that over the past year or so, the unemployment rate has generally edged up from around 5.0% to around 5.25%. Fact.
But what happened in 2004?
During that year, the unemployment rate drifted lower – from around 5.5% at the start of the year to around 5.25% by the end, yet mortgage interest rates were unchanged at 6.75% … right through the year. The RBA did not adjust monetary policy at all in 2004.
During 2005, the unemployment rate was again steady to slightly lower. It drifted from around 5.25% to around 5.0% by year end - a nice result but hardly a rapid move to an overheated labour market. In March of 2005, the RBA delivered the only rate rise for the year with a single 25 basis point rate rise. It cited “higher employment costs” as a reason for the hike. Mortgage rates edged up to around 6.95%.
See the pattern? Over a two year period where the unemployment had very slowly, but very assuredly edged down from 5.5% to 5.0%, mortgage interest rates were around 6.75 to 6.95%.
I would also note that over these two years, fiscal policy was also generally stoking the fire with real government spending rising 3.9% in 2003-04; 3.5% in 2004-05 and a tub thumping 4.6% in 2005-06. That’s 12.5% real growth in government spending in 3 years. Due to a record tax to GDP ratio, there was a 0.7% of GDP rise in the underlying cash Budget balance over that 3 year period.
Only in 2006, as the unemployment rate fell well below 5.0% and actually ended the year around 4.5% did the mortgage rate rise substantially, - it reached 7.6% by the end of 2006.
Which brings us to now.
As mentioned, unemployment rate has inched up to around 5.25% having been a touch below 5.0% a year or so ago. Aided by RBA monetary policy decisions, but hurt by wholesale funding conditions, mortgage rates have only fallen a bit and are now around 7.4% - as you can plainly see, a rate 50 to 75 basis points higher than when the unemployment rate was at similar levels and falling 6 or 7 years ago.
I note that in terms of fiscal policy in this cycle, real government spending fell 0.4% in 2010-11, will rise 3.7% in 2011-12 but will fall by a near record 3.0% in 2012-13. This is a total rise of around 0.2% in government spending in 3 years. The Budget balance will contract by a record 4.3% of GDP in those 3 years.
So there we have the contrast: The last time the unemployment rate was in the low 5s, mortgage interest rates were some 50 to 60 to 70 basis points lower than where they are now, and that was with public demand adding to inflation risks.
We now have unemployment in the low 5s, fiscal policy is tighter than a bass drum yet the mortgage interest rate is 7.4%.
The bottom line is that the RBA has oodles of scope to be cutting interest rates and only in recent times has the Bank realised this. It knows it has to catch up – it knows banking funding cost pressures mean they will have to cut official rates harder to achieve the same impact on mortgage interest rates by way of example. It also knows that overall activity is still on the soft side.
So get set for a 50 basis point cut in official interest rates in May. Such a move is essential if the RBA is to catch up to where rates should be – that is, with mortgage rates at 7.0% or a little less.