The Urgency for an Interest Rate Cut Intensifies

Some of the reasons why the RBA needs to cut interest rates and cut soon were outlined in the Op Ed piece published in the AFR today (  http://alturl.com/kwngb  - a full version reproduced below).

In addition to what should be obvious economic indicators such as sub-trend economic and employment growth, entrenched low inflation and an increasingly over-valued Australian dollar, we are now starting to see the impact of a softer Chinese economy coming through in corporate news.

In recent weeks (and most noticeably since the March RBA Board meeting), China has lowered its growth target to 7.5%, while BHP and other mining companies are highlighting a flattening in demand for minerals and energy from Chinese importers.  Prices for some of these commodities is also softening.

Broad global commodity price indices remain soft, particularly in Australian dollar terms, suggesting that inflation pressures are neutral at worst and probably actually skewed to the downside.

In being reluctant to cut interest rates in this current cycle, the RBA has placed a massive amount of importance on the mining industry and China.  As outlined in my Op Ed article today, this over-cooking of the mining goose is leaving the whole economy in muddle through mode, rather than moving along at a pace nearer potential.

If the RBA remains true to its faith on the importance of mining and China, the recent news will only magnify the need for rate cuts.

A 3.5% cash rate remains on the cards for sometime in the next little while, but the longer the RBA holds off delivering those cuts, the greater the downside risks to that outlook – ie, even more cuts will be needed.

OPINION

Why RBA needs to cut rates

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STEPHEN KOUKOULAS

In the past year, the Reserve Bank of Australia has made an error by placing too much weight on the mining boom and the overheating in that sector. At the same time, it has underplayed the weakness in the rest of the economy, which has been constrained by the strong Australian dollar, the substantial fiscal policy tightening, restrictive interest rates and global issues. Interest rates have remained higher than would have been the case had the RBA given more weight to the negative influences and scaled back its magnified optimism on mining.

Economic growth in 2011 was an anaemic 2.3 per cent, bringing the period of sub-3 per cent growth to nearly four years. At the same time, underlying inflation fell to an annualised rate of 2 per cent in the final six months of 2011 and employment growth stalled.

Financial markets think the RBA has held monetary policy too tight for too long as shown by the fact that the yield curve is trading below the cash rate, the Australian dollar is strong despite less favourable fundamentals and shares are underperforming their global peers.

The reluctance of the RBA to cut interest rates further is surprising given the spectacular back-tracking on its gross domestic product forecasts in 2011. In February 2011, the RBA forecast GDP to rise by 4.25 per cent through 2011 and by 4 per cent in 2012. This is why it had monetary policy at a restrictive level. By August, the RBA massively scaled back its growth forecasts to 3.25 per cent for 2011, but it held the 3.75 per cent forecast for 2012. This looked optimistic but the RBA held to its view the mining boom would underpin above trend growth.

In November and December, the RBA cut interest rates and had to acknowledge a further downgrade to its GDP forecasts, this time to just 2.75 per cent and 3.25 per cent, respectively, for 2011 and 2012. The concern now is that these massive revisions have not gone far enough. The recent national accounts confirmed this with growth in 2011 of just 2.3 per cent.

The RBA’s forecasting error extended to underlying inflation, which it forecast to rise 3.25 per cent through 2011. In the event, it rose by only 2.5 per cent. Despite these dramatic downward revisions, the RBA has cut interest rates just 50 basis points with less than that flowing to borrowers.

By not cutting rates this year, the RBA has undermined confidence, restricted credit growth, and locked in an unnecessarily long period of economic underperformance. Business and consumer sentiment are weak and the near-term outlook for the economy is problematic.

The RBA can address this easily by lowering official interest rates to ensure the economy does not have to deal with another year of sub-trend growth. An interest rate cut in April would be a good move.

Stephen Koukoulas is managing director of Market Economics and was economics adviser to Prime Minister Julia Gillard.