The Reserve Bank of Australia’s decision not to cut official cash rates this month may well be a mere pause before it lowers rates again in May.
But whether the RBA cuts rates down the track or not won’t directly impact business activity in the Australian economy. Rather it is the value of the $A that will ultimately determine the level of business confidence and generate activity.
Today, the RBA is hostage to offshore central bank policies and the only way out is to ditch its rigid free market beliefs that limit its activity to setting rates. It needs to take more concrete action to stimulate the domestic economy.
Ending the carry trade
Most commentators have said the RBA is looking at cutting rates to stimulate economic activity. We don’t believe that is entirely accurate.
The RBA is actually engaged in a war over the $A as it tries to defend Australia’s national income. It has cut rates – and is looking to cut further – in direct response to the zero interest rate policies offshore.
Figure 1. Terms of trade
Source: ABS, RBA
Australia needs the $A to fall to reflect the sharp decline in our terms of trade in the wake of the crash in commodity prices such as iron ore. Otherwise our trade account will take a severe jolt.
Australia’s interest rates are still relatively high on a global basis. That means money flows into Australia seeking those yields, which is keeping the $A high. The RBA is trying to stop that ‘carry’ trade.
The job has just become more difficult
The RBA, no doubt, would have been counting on help from the US. Rates there were expected to start rising on the back of a rebounding economy.
Unfortunately, the US economy seems to have stalled in March. Jobs creation slowed and GDP didn’t grow in real terms during the quarter. And remember that is low growth supported by low interest rates!
The slowing of the US economy causes issues for the RBA. A weak US economy means the likelihood of US rates rising gets delayed. So the relative attractiveness of the $A is maintained.
That continues to put upward pressure on the $A at time when iron ore prices are crashing.
The RBA and the Government need to come up with some different responses
At some point the RBA will need to realise that cutting cash rates is a weak tool in a world where real interest rates do not exist.
The rest of the world is operating on a completely ridiculous interest rate mechanism, with zero rates in America, negative rates in Europe, and rates well below the inflation rate in Japan, etc.
Therefore the RBA needs to think about other mechanisms and the Australian Government must co-ordinate its fiscal policy.
We believe there are four key things the RBA and the Government should consider:
- Support capital moving to productive enterprises and essential infrastructure through direct government investment or grants.
- Lower Australia’s corporate taxation rate.
- Offer tax breaks for investments by Australian companies that generate export income or to international companies who domicile their Asian operations in Australia.
- Restrict or tax speculative capital inflows into the country.
But this will be hard because the RBA and the Australian Government typically do not like regulation; they appear to strenuously believe in free trade and free markets.
There are several ironies here: the RBA believes in a free market, but no one in the rest of the world is operating in a free market. Think QE, fixed exchange rates and zero interest rates.
And in any case, cutting interest rates is a reflection that markets aren’t free; it’s an admission that offshore markets are manipulated, working for themselves and against us.