Australia | Feb 20 2008
By Greg Peel
One of the great ironies of the 2007 election in Australia was that the incumbent conservative government was promising to throw money at even the lowest paid of workers while the aspiring socialist government was preaching restraint. Howard promised across the board tax cuts that conjured visions of him riding around in a helicopter tossing out cash, while Rudd offered some tax cuts as an incentive but preferred to otherwise increase efficiencies. Had you been trying the use this example to define the difference between the Right and the Left to a political economics student, that student would have been very confused.
The prime minister must now be wondering, in rare quiet moments, whether he could have won the election anyway by promising no tax cuts at all. In hindsight it appeared Howard was doomed either way. For Rudd now faces the difficult prospect of his first term going down in history as one in which the government presided over destructive inflation growth, whether or not it’s any fault of the newcomers. Labor governments of the past have done the same – Whitlam the obvious example – with unfortunate consequences. Rudd must feel he could almost renege on his promised tax cuts and the Australian people would understand. But that would be to elicit a probable “here we go again” response from a population beaten into submission by a decade of “core” and “non-core” promises.
So the tax cuts will go ahead – on top of the previous cuts written into legislation by the former government. The RBA is well aware of this despite the fact fiscal policy is no concern of a central bank. It is the central bank’s role to keep inflation at bay, and it has strongly indicated it will do whatever it takes to achieve this goal. In other words, more interest rate pain.
JP Morgan economists calculate that the forthcoming tax cuts will leave the average mortgage holder on a variable rate mortgage just ahead after the February rate hike. Any subsequent rate hike will, however, tip householders into the red on a net cut/hike basis. It looks like that will happen in March, and probably again in May. Indeed, Macquarie economists suggest if the RBA is to successfully reduce inflation back into the target zone the cash rate may need to be as high as 8.00%. That’s another four hikes of 25 basis points.
If the cash rate is 8% then standard variable mortgage rates can rise to 10%.
Macquarie bases its forecast on the plight of the consumer. Increased borrowing rates do not just affect households or individuals, they affect business and government spending as well. But with Australia running at full capacity and full employment businesses must continue to invest, and thus continue to borrow. The data show there has been no let up in business credit growth. As the world demands more and more of Australia’s commodities, exports are growing, bringing increased income into the country through an improving balance of trade. And governments, both federal and state, have been behind the times on infrastructure spending. Grand plans are afoot to address this tardiness.
All of the above will continue despite interest rate hikes. Thus the only scapegoat left to bear the brunt of the RBA’s battle to reduce domestic demand is the humble consumer.
Macquarie has used a couple of different approaches to figure out just how frugal consumers need to become to singularly bring inflation back under control. The RBA suggests even if Australian GDP growth fell to 2.75% inflation would still remain above 3% until 2010. Macquarie calculates that in order to bring GDP growth down to at least 3% would require consumer spending growth to fall below 2% (from 4.2% now). This level has been reached only three times in the past fifteen years – in 1992, 1996 and 2001.
On each of the above occasions, the fall in consumer spending coincided with an increase in the real cash rate (RBA target minus inflation) to at least 4%. The current real cash rate is the RBA’s 7%, minus 3.5% inflation, or 3.5%. Thus the RBA must push up rates three more times (75bps) to reach beyond the 4% real rate mark. That’s 7.75%.
However, on each of the past three occasions consumer spending only briefly fell below 2% before recovering. With oil at US$100/bbl and food and other commodity prices soaring, in order to really tame inflation the RBA will need to curb consumer spending for a more prolonged period this time. Furthermore, the Australian population is growing rapidly, thus introducing new consumers (particularly in the case of immigration). Again, this implies even more vigilance is needed by the central bank.
Hence Macquarie believes the RBA will have to take rates up a full 100bps from here – to 8%.
Now let’s return to those tax cuts. Macquarie notes total tax cuts ahead will be worth $6.5 billion from Rudd plus another $1.5 billion promised already by Howard. That’s $8 billion. Taking the average level of Australian household debt, and the number of variable mortgages, Macquarie calculates that each 25bps of interest rate hike increases total interest payments by $1.75 billion per year.
Thus in order to cancel out the hand-outs due to consumers in the next two years interest rates need to rise by – you guessed it – 100bps. However, we’ve already had the February hike, and banks have increased their SVRs ahead of the RBA anyway. So perhaps only 50bps is needed from here to cancel out those tax cuts.
But that just gets us back to square. As noted in the earlier calculation, the RBA has to reduce consumer spending growth, not stall it.
Macquarie admits its calculations have a few holes that could attract criticism. However, which ever way you look at it the message is clear. Indeed, Macquarie points out one can arrive at the same 8% conclusion using the RBA’s own methodology.
A recent RBA discussion paper suggested that a 100bps increase in rates would reduce GDP growth by 1.3% after nine months, and reduce inflation by 0.4% after nine months. Thus with inflation currently at 3.6% a 100bps increase is still needed.
All of this, nevertheless, assumes the RBA is correct in believing the inflation rate will rise before falling and remain above 3% until 2010 were monetary policy not tightened. The RBA might be wrong. Inflation could peak mid-2008, as the RBA was forecasting as recently as late last year, and maybe one or perhaps two more hikes are all that’s needed. But what could bring about this less hawkish scenario?
Well – the price of oil could fall, thus reducing that inflationary effect. When US recession talk became all the rage oil did try to move meaningfully back below US$90/bbl, and many an economist believes this will still happen as the US slows down. But it would also probably require Venezuela and Exxon to kiss and make up, Nigeria to declare peace, OPEC to suggest it’s happy to keep producing at peak levels even as the oil price falls, and developing countries to also begin curbing their own oil demand growth.
And pigs to fly?
Realistically, we could still face a recession in the US, Europe and Japan (Japan’s latest figures were very strong), which would then undermine the runaway economies of China in particular, and other developing nations in general, which in turn would slow down the Australian economy without any need for RBA intervention. If this is not what transpires, then triple-digit mortgages are around the corner.