The betting money now is that the RBA will leave the cash rate as it is in May.
Recent tapering of the unemployment rate plus tearaway auction clearance rates in Sydney and, to some degree, Melbourne, are to blame.
But our analysis shows that interest rates need to fall, and maybe several times, in order to expand our domestic economy.
Our first chart shows that on a trend basis our unemployment (u/e) rate remains high.
At present it is 6.2%.
Close to 770,000 people are looking for work; according the ABS: 550,000 for a full-time job & 220,000 for something more casual.
When u/e is low, wage growth increases & core inflation tends to rise.
A central bank lifts interest rates to slow inflation.
The opposite should apply when u/e is high & rising.
Chart 1 also depicts a natural rate of u/e – that is the level of u/e which stabilises core inflation at 2.5%, which as shown in chart 2, is in the centre of the RBA inflation target range.
Work done by Morgans suggests that Australia’s natural u/e rate is around 5.4%.
Their modelling also indicates that for each 1% rise in u/e, Australia’s inflation rate falls by 0.9%.
Again, Australia’s u/e rate is 6.2% & the headline annual inflation rate is just 1.3%, which is well below the RBA target CPI band.
See chart 2, again.
Not only is inflation under control, we also have an economy in transition
We are transforming from a high capital demand economy resources boom, to a low capital demand one, driven by investment in services & new housing construction.
This transition is also being hampered by falling population growth; low productivity plus (as outlined in a recent missive), a now oversupplied new housing market.
This lessening in demand for capital should lead to lower short-term interest rates.
This, in turn, suggests that the yield curve (10 year bonds minus 90 day bank bills) is a better marker for setting interest rates than inflation.
History (again using Morgans work) indicates that short rates 0.5% lower than long rates should be regarded as neutral monetary policy.
See chart 3.
Our table illustrates that the housing boom is really all about Sydney.
Little is happening, price expectation or escalation-wise, outside of Sydney.
Australia is often described as ‘Sydney or paddocks’, but I think of it more like a game of ‘Chinese roulette’.
If you want to slow Sydney’s house market, implement some half decent FIRB laws & enforce them.
But don’t let Sydney’s irrational exuberance blindside you; interest rates are too high.
Chart 3 suggests that the current cash rate, at 2.25%, is way too tight.
The current cash rate setting is restricting the economy, it isn’t expansive at all.
The cash rate needs to fall at least 0.5% before it even starts to help.
FROM MICHAEL MATUSIK –
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