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.