Saul Eslake writes for Troppo

Saul, who needs little introduction, has kindly accepted my invitation to occasionally post on Troppo.   Saul is a wise and moderate fellow and you could do worse than accord his thoughts on the economy as much weight as you give anyone else.

Over the fold is an article Saul has just penned on the future of interest rates.
Be prepared for interest rates to rise again

(Article written for Accelerated Answers (pdf), a client newsletter produced by ANZ Margin Lending’ on 20th August 2006).

Every article I have written for Accelerated Answers over the past year has warned that interest rates are likely to rise. And this one will be no exception, even though the Reserve Bank has already lifted the cash rate twice this year more in three months than over the previous two years.

This month (September) marks the 15th anniversary of the end of the last recession (of 1990-91). Since then, the Australian economy has experienced only two quarters of negative growth in the September quarter of 1993, and in the December quarter of 2000 (following the introduction of the GST and the Sydney Olympics). There have not been two or more consecutive quarters of negative growth (the textbook definition of a ‘recession’) since 1991. This is the longest period without consecutive quarters of negative growth that Australia has experienced since quarterly economic growth data were first published in 1959.

Indeed, the past 15 years almost certainly constitute Australia’s longest period of uninterrupted economic growth since Federation in 1901, if not since European settlement began in 1788.

Since avoiding recessions is one of the cardinal objectives of economic policy, this achievement is, in almost every respect, a Good Thing. It is, for example, one of the main reasons why, in recent months, unemployment has fallen below 5% for the first time in thirty years; and why real per capita household disposable incomes have risen by more than three times as much over the past fifteen years as they did over the previous fifteen.

It does however also mean that the Australian economy is starting to run into ‘capacity constraints’ which prevent it from achieving the rates of growth it has attained over the past fifteen years without encountering some strains. These ‘capacity constraints’ including growing shortages of skilled labour; declining office vacancy rates; and ‘bottlenecks’ in various forms of infrastructure such as roads, ports, electricity and water supply.

Typically, when an economy starts to run into ‘capacity constraints’ such as these, businesses encounter increasing cost pressures. In the face of shortages of skilled labour, employers may become more willing (or be forced) to offer increased wages to attract or retain key staff; supply ‘bottlenecks’ may cause costly delays or prompt businesses to be willing to pay higher prices to avoid them. Many Australian businesses have been confronting these pressures for some years now, together with rising prices for oil and other raw materials.

In some cases, businesses can offset these cost increases by finding savings elsewhere in their operations, or by improving productivity. But many businesses will also seek to recoup cost increases by raising prices to their customers. Whether they can succeed in doing so depends on, among other things, the extent to which they face competition from other businesses with different cost structures (including imports); and the strength of demand for their products.

If enough businesses are able, on a sufficiently wide scale, to pass on cost increases to their customers in the form of higher prices, the overall result will be an acceleration in inflation.

And if this is in turn sufficient to push the inflation rate abstracting from any temporary influences such as the recent surge in banana prices close to or above the 2-3% target band within which the Reserve Bank is required (by the Government) to keep the inflation rate on average over the course of the business cycle then the Reserve Bank will typically seek to make it harder for businesses to make price increases ‘stick’, by raising interest rates with a view to dampening the rate at which demand for goods and services is growing.

Although growth in household demand for goods and services had slowed in the wake of the easing in the property market (at least on the eastern seaboard of Australia) from late 2003 onwards, so that most businesses found it difficult to recoup cost increases by raising prices, so far in 2006 consumer demand has picked up again, and the ‘core’ inflation rate has accelerated from 2 ½% per annum to around 3%, at the top of the Reserve Bank’s target range.

Domestic demand for goods and services has been boosted by two strong influences. First, the China-driven boom in commodity prices, which has dramatically lifted the earnings of Australia’s mining sector, and triggered a massive investment boom (particularly in the west and north of Australia). This effect has been complemented by the (again largely China-driven) fall in the prices of a growing range of imported goods. Together, these influences are boosting Australia’s real income by more than 1% per annum.

Second, household incomes are being boosted by the large tax cuts and other spending measures announced in the past two Federal budgets.

In aggregate, the income tax cuts which took effect on 1 July will add around $9 billion to household disposable incomes in the 2006-07 fiscal year.   For the household sector as a whole, this more than offsets the net impact of the increases in interest rates in May and August (which will cost Australian households around $3 ½ billion this fiscal year) and the increase in petrol prices since the beginning of 2006 (which will cost them around $3 billion per annum).

The tax cuts have been largely funded out of the massive windfall revenue gains which the Federal Government is reaping from the resources boom (via the company tax system). Rather than ‘saving’ these windfalls by running larger-than-expected Budget surpluses, the Government has chosen to hand them over, almost entirely, to households in the form of tax cuts, family tax benefits and the like. And this has effectively ‘neutralized’ the Reserve Bank’s efforts to dampen growth in domestic demand for goods and services so as to keep inflation within its target range.

As the Reserve Bank has pointed out in recent statements, despite the two rate rises this year (bringing to seven the total number of increases in interest rates from the low point reached in 2001-02), interest rates actually paid by borrowers are still lower than they have been, on average, since the onset of the ‘low inflation’ era in the early 1990s.

At this stage of the business cycle, with the economy running into ‘capacity constraints’ and yet with demand being stimulated by the ‘China boom’ and by government largesse, it is almost inevitable that interest rates will need to move higher if the inflationary pressures which are typical of this stage of the business cycle are to be contained. Indeed, it has been the failure to contain these inflationary pressures which has sown the seeds of every recession which Australia has experienced in the last fifty years.

Borrowers should thus brace themselves for another ¼ percentage point in interest rates within the next six months, and be alert to the possibility of a further rise in the six months after that.

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Jonno
Jonno
15 years ago

It’s very welcome as it’s hard to find Saul’s writings elsewhere!

whyisitso
whyisitso
15 years ago

The Labor Party that criticises the Government for being the highest taxing government since federation also has the gall to accuse it of indiscipline in fiscal policy, thus making it more difficult for the Reserve bank to keep a lid on inflation.

Gittins and Co criticise the government for wrongly taking credit for economic management that has led to the 15-year economic growth when it’s really the Reserve Bank that should get all the credit for the way in which it manages monetary policy. No credit is due to Howard and Costello, of course, for giving the Reserve Bank independence in the first place!

Managing an economy is a fine balancing act that most Australian governments prior to this one have failed in. Something’s being done right. If all we get in this monetary cycle is another two interest rate increases totalling 0.5% we’ll have done spectacularly well compared with every cycle since the sixties.

taust
taust
15 years ago

It would appear that in addition to interest rate rises we need to reduce the capacity constraints by opening more sectors of the economy to overseas competion and to minimise competition from overseas money in ‘domestic’sectors of the economy like housing.

fatfingers
fatfingers
15 years ago

It’s ‘nice’ to get Mr Eslake’s opinions in ‘greater’ depth than the 12-second soundbite ‘he’ is normally accorded on the ‘nightly’ news. But what ‘is’ it with Saul’s constant ‘quote’ marks?

Saul Eslake
15 years ago

Actually anyone who is interested in things which I and my colleagues write can find them at http://www.anz.com/go/economics

Jonno
Jonno
15 years ago

Thanks – that seems to provide far more information than I would expect on
such a site. I would be interested on your views on the current account
deficit.

Saul Eslake
15 years ago

In some ways it’s odd that at a time when our terms of trade (the prices we receive for our exports relative to the prices we pay for our imports) are more favourable than at any time since 1973, we are running a current account deficit of around 6% of GDP. Indeed when the terms of trade were last as favourable as they are today, in 1973, was the last occasion on which Australia ran a current account surplus.

That we are still running a large deficit in these circumstances partly reflects the fact that (at least up to the March quarter of this year – the June quarter figures will be released in early September) there had not been any significant increase in the volume of exports (partly as a result of the capacity constraints noted in my original article); and partly because, since as a nation we are spending virtually all of the proceeds of the higher prices we’re now receiving for our resources exports, a proportion of that is spilling over into an increased volume of imports. In addition, foreign interest rates are now rising, increasing the cost of servicing the foreign debt; and, as a result of the growing foreign ownership of Australia’s resources industry, an increasing proportion of the profits earned by mining companies shows up as payments of equity income abroad.

At the risk of sounding simplistic, which I don’t mean to, the current account deficit is a problem in the short term only if the financial markets think it is. And in recent years, they haven’t thought it a problem: they’ve been willing, indeed (as evidence by the rise in the A$ over the past four years) more than willing, to finance it. This may be partly a result of the generally easy liquidity conditions in global financial markets in recent years – most countries running large deficits (most obviously the United States) have encountered much less difficulty financing them than even relatively sanguine observers had anticipated.

However there are two, and maybe three, longer-term problems or risks arising from Australia’s persistently large current account deficits.

The first is that Australian interest rates will almost always be higher than in major global financial centres (independently of whether our inflation rate is higher or lower than in other countries) in order to attract the capital we require to finance the deficit.

The second is that Australia will always be vulnerable to shifts in sentiment among foreign lenders (and financial markets more broadly) that may be entirely unrelated to developments in this country but which nonetheless make financing our deficit more onerous. Just as it was commonly said, after the recession of the early 1990s, that banks had become more cautious about financing viable businesses because of the credit losses they had incurred during that recession (I’m not affirming that, simply acknowledging that the charge was often levelled), it’s possible to contemplate circumstances in which countries running large surpluses (Japan, China, other Asian nations and oil-exporting nations) become much more reluctant to accumulate foreign assets (eg by lending to nations incurring deficits). In such circumstances, Australia could find itself confronting abruptly higher interest rates, or a sharply weaker exchange rate, with deleterious consequences for our ability to sustain the rates of economic growth to which we’ve become accustomed.

The third possibly disconcerting consequence of running persistent large current account deficits is that ownership of an increasing proportion of our assets may pass into foreign hands – to the extent that our deficits are financed by equity rather than debt inflows. Whether one views this as a problem is partly dependent on one’s views about the desirability or otherwise of foreign investment. But, as I noted earlier, one result of increasing levels of foreign ownership of Australia’s resources industry, a growing proportion of the fruits of the current resources boom is accruing to foreigners rather than Australians.

PS: I hope ‘fatfingers’ has observed with satisfaction that I’ve written the above without using any inverted commas at all. It’s true, I tend to use these when using a colloquial expression in a specific economic context, and perhaps I ‘over-did’ it (oops, there I go again!) in this article.

Fyodor
15 years ago

Saul,

Great to see you blogging. Welcome to Ozblogistan!

Cheers,

Some bloke you’ve never heard of

Bring Back EP at LP
Bring Back EP at LP
15 years ago

the problem of the current account will only occur when the terms of trade starts to deteriorate and the market will change its mind as it has in the past.

At the moment our outrageoussly large current account deficit is ignored because of the terms of trade