From Bloxo:
As mining investment and commodity prices fall, Australia needs growth to shift to the non-mining industries. A record-low RBA cash rate setting is helping to make this happen by supporting the most interest rate sensitive sectors of the economy.
Housing prices are rising rapidly, a housing construction boom is underway, household durable goods sales are picking up and equity markets have rallied. But the next stage has yet to take hold. The recovery in hiring and investment by nonmining businesses has been tepid at best. For further recovery to occur an improvement in confidence is needed and monetary policy is unlikely to be capable of driving this on its own. Confidence has been held back by a range of factors, including a lack of clear direction on fiscal policy. Weak business confidence is one of Australia’s key economic problems.
As we have written for some time now, Australia needs to pull off a great rebalancing act.
Historically high commodity prices, which peaked in 2011, drove the biggest ramp up in mining investment in Australia’s history, which peaked in 2012. Mining investment went from 4% of GDP to 8% of GDP in a short few years, but that level was never to be sustained. We are now on the downside of the mining boom. Mining investment and commodity prices are falling, acting as a drag on GDP and income growth. Growth in the non-mining sectors – which account for 80-90% of Australia’s economy – needs to pick-up.
The RBA saw much of this mining cycle dynamic coming. Although, as is always the case, there has been significant imprecision in forecasting the exact timing and magnitude of the mining investment and commodity prices cycle. To stimulate the non-mining sectors, they have cut their cash rate by 250bp from a peak of 4.75% in late 2011. Their cash rate had been at an historic low of 2.50% in the 18 months up to this month, when they cut the rate even lower, to 2.25%.
Monetary policy is working. There are clear signs that low interest rates have been lifting the most interest-rate sensitive sectors of the economy. Housing prices have risen by 22% since their trough in mid-2012. Dwelling approvals are at record highs, with over 200,000 housing units approved for construction over the past year. Sales of durable goods are up 10% y-o-y as people fill their new, higher priced houses with furniture. Australia’s share market reached its highest level in over six years last week.
But this is not enough. The next stage is that non-mining businesses need to increase their hiring and investment. This part of the recovery has been tepid at best. Although employment growth has lifted modestly, the pick-up has not been enough to stop the unemployment rate from trending higher. Non mining businesses have also been unwilling to ramp up their capital spending plans.
Business confidence has been low.
But why is business confidence weak? Interest rates have not been the constraint. Rates are very low, firms have low leverage and banks are willing to lend. For some firms, the problem has been the high cost of doing business in Australia. The fall in the Australian dollar over recent years has helped, but an even lower currency would provide further help. The RBA still believes the AUD is overvalued and we do too. Some firms have been discouraged by labour and product markets and a regulatory environment that has been less conducive for growth than is ideal, due to a lack of reform.But, the biggest challenge to business confidence, in our view, has been a lack of certainty about the direction for government policy in the post-mining boom period. Uncertainty about government policy, particularly fiscal policy, has kept businesses cautious about making big hiring and investment decisions.
With fewer signs of a recovery in the non-mining sectors than they had hoped for, the RBA delivered a surprise cut in their cash rate at their first meeting this year, in early February, to a new record low of 2.25%. The central bank also lowered its GDP forecasts and delivered dovish rhetoric, which has seen the market now price a 50:50 chance of a follow-up 25bp cut in March and a cash rate of 1.75% by the end of 2015.
The RBA cut involved a substantial change of rhetoric. As recently as mid December 2014, the RBA had been saying that it was not the level of interest rates that was constraining businesses. They were also saying that lower interest rates could risk over-inflating an already booming housing market, particularly in Sydney. Despite this, they cut rates further, knowing full well that there are now diminishing returns from even lower interest rates. It appears that they just lost patience with the pace of rebalancing and with only one tool to respond, they felt the need to deliver more stimulus. Given the tone of their commentary, we expect they are likely to cut again soon.
Without a pick-up in confidence, Australia’s rebalancing act will remain slow. Monetary policy is reaching its limits and may already be doing little to boost confidence. This year’s Federal budget is critical. The government needs to get the right balance of supporting short-term growth, by not tightening the screws too much, setting out credible plans for medium-term consolidation and reform, supporting the much needed building of infrastructure and, most importantly, giving businesses a clear sense that government policy has direction. Further reliance on monetary policy as the sole instrument for driving Australia’s rebalancing act is fraught and risks the unintended consequences of inflating asset price bubbles. We remain medium-term optimists about Australia’s growth but see a number of challenges in the short run.
Not a bad summary. Fiscal chaos is sure a problem for the old economic model.
However, the bigger issue is the great household debt overhang, which is why consumption remains so suppressed relative to recent history. During the millennial period Australia restructured its economy towards FIRE sector growth, but the transmission system in the loop from finance to asset prices to consumption is now broken.
Like elsewhere, financial repression forces folks to play in inflated asset markets but they no longer believe they are a reliable store of savings so don’t spend the gains.
Hence there is overcapacity and no need to invest in anything. “Confidence” is a long run second to this structural problem but the Pitchford people just can’t admit it and are going to drive their model off the edge of the earth.
