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We consider the point in the economic cycle we are in, given the Fed’s move last week. Meantime, in Australia, how close to the brink are we now?
We consider the point in the economic cycle we are in, given the Fed’s move last week. Meantime, in Australia, how close to the brink are we now?
Last Friday the Treasury released a draft bill which would ban cash transactions above $10,000. But I discuss the real story, with the CEC‘s Robbie Barwick. It has more to do with negative interest rates than may first appear.
Email: blackeconomy@treasury.gov.au with the subject line:
Submission: Exposure Draft—Currency (Restrictions on the Use of Cash) Bill 2019
The Federal Reserve appears to be bailing out the president. From The US Conversation. The central bank is essentially signaling it’s now the administration’s insurer of last resort.
Responding to concerns of a slowing economy – in part caused by President Donald Trump’s trade wars – the Fed cut short-term interest rates for the first time since 2008, lowering its benchmark rate 25 basis points to 2.25%.
The cut sends a message to financial markets and households that the Fed stands ready to give the economy a boost should it slow further. Given that it’s forced to do so by Trump’s own policies, the central bank is essentially signaling it’s now the administration’s insurer of last resort.
As an expert on monetary policy and a former Fed economist, I believe the bank’s embrace of this role is bad for the economy. It could embolden Trump and other politicians to pursue policies that are even more reckless – the kind intended more to benefit narrow constituencies and help win their re-election than support the broader national interest.
Judging the merits of a rate cut usually can only be done in hindsight. But the case for one seems to be more about what it signals than directly boosting growth.
By itself, a single quarter-point reduction in the overnight borrowing rate – the rate most directly affected by the Fed – will likely do little to alter directly the economic decisions made by consumers and companies. Virtually no households, and very few businesses, borrow money for such a short term.
Most mortgages, for example, are of the 30-year, fixed-rate type. And while the Fed’s short-term “target” does eventually affect other interest rates in the economy, long-term borrowing costs typically react less to modest changes in monetary policy, especially if these changes are “one-off.”
Rather, it’s the message that matters. Stoking expectations that the Fed stands ready to provide additional monetary easing if necessary is a powerful tool. And although rates are historically low, the central bank still has another 2 percentage points it can cut to stimulate the economy, as well as similar tools like so-called quantitative easing.
Furthermore, although the economy has slowed slightly, it’s still growing. Some argue that the “insurance” of a rate cut – and the signal it provides that the Fed stands ready to do more – will help maintain that positive growth.
But the very reason the Fed feels the need to do this is because of the government’s own policies. Most economists agree that the current round of tariffs and the resulting disruptions to supply chains have been harmful.
Normally, economic conditions play a big role in presidential elections. And as the political and economic costs of a bad policy mount, a president would be forced to switch course to avoid doing more harm – not to mention damaging his re-election chances.
Therein lies the problem of the Fed’s rate cut. Its commitment to reducing rates to stimulate the economy regardless of the source of the slowdown insulates the administration from the consequences of its actions, potentially leading to even more misadventures.
Not only that, cutting rates drives up the prices of risky assets – which could metastasize into something harmful, as we saw ahead of the 2008 financial collapse – and masks other structural problems in the economy. Furthermore, rate cuts tend to primarily benefit the upper middle class and the wealthy – the group that owns most of the financial assets in the economy.
History shows that this kind of central bank insurance is not free.
In the 1970s, President Richard Nixon pressured Fed Chair Arthur Burns to keep interest rates low in order to help him win re-election in 1972. Ultimately, Burns acquiesced, Nixon won re-election, the Vietnam War continued for three more years, and the U.S. economy suffered high and disruptive inflation throughout most of the decade.
Something similar could happen if the Trump administration provides even more fiscal stimulus to bolster its 2020 election chances. Fed rate cuts in conjunction with additional fiscal stimulus could result in higher inflation – which could spook markets and lead to a nasty unwinding.
Author: Rodney Ramcharan, Associate Professor of Finance and Business Economics, University of Southern California
The Fed cut interest rates on Wednesday for the first time since the financial crisis, as had been expected, citing slowing business investment and below target inflation.
The Fed cut interest rates on Wednesday for the first time since the financial crisis, as had been expected, citing slowing business investment and below target inflation.
In fact, U.S. President Donald Trump had been calling for a rollback, making unprecedented attacks on the central bank and Chair Jerome Powell, which raises questions about its independence.
In reaction, following the first cut in a decade, the Dow and S&P 500 suffered their biggest daily percentage drops in two months. But Fed Chair Jerome Powell dampened expectations for further cuts going forward, calling it a “mid-term policy adjustment.” So, the Fed appears to be in no rush to continue with easing, unless new data supports the need to move. Two officials dissented to this cut, which therefore may not be the part of an easing cycle.
This disappointed the market as it means asset prices may not get so stretched. At the close in NYSE, the Dow Jones Industrial Average lost 1.23%, while the S&P 500 index lost 1.09%, and the NASDAQ Composite index lost 1.19%.
The CBOE Volatility Index, , was up 15.64% to 16.12 a new 1-month high.
Meantime, the U.S. Treasury Department announced plans to maintain record debt sales as Congress and Trump continue a spending frenzy that’s widening the deficit even as economic growth remains solid.
Information received since the Federal Open Market Committee met in June indicates that the labor market remains strong and that economic activity has been rising at a moderate rate. Job gains have been solid, on average, in recent months, and the unemployment rate has remained low. Although growth of household spending has picked up from earlier in the year, growth of business fixed investment has been soft. On a 12-month basis, overall inflation and inflation for items other than food and energy are running below 2 percent. Market-based measures of inflation compensation remain low; survey-based measures of longer-term inflation expectations are little changed.
Consistent with its statutory mandate, the Committee seeks to foster maximum employment and price stability. In light of the implications of global developments for the economic outlook as well as muted inflation pressures, the Committee decided to lower the target range for the federal funds rate to 2 to 2-1/4 percent. This action supports the Committee’s view that sustained expansion of economic activity, strong labor market conditions, and inflation near the Committee’s symmetric 2 percent objective are the most likely outcomes, but uncertainties about this outlook remain. As the Committee contemplates the future path of the target range for the federal funds rate, it will continue to monitor the implications of incoming information for the economic outlook and will act as appropriate to sustain the expansion, with a strong labor market and inflation near its symmetric 2 percent objective.
In determining the timing and size of future adjustments to the target range for the federal funds rate, the Committee will assess realized and expected economic conditions relative to its maximum employment objective and its symmetric 2 percent inflation objective. This assessment will take into account a wide range of information, including measures of labor market conditions, indicators of inflation pressures and inflation expectations, and readings on financial and international developments.
The Committee will conclude the reduction of its aggregate securities holdings in the System Open Market Account in August, two months earlier than previously indicated.
Voting for the monetary policy action were Jerome H. Powell, Chair; John C. Williams, Vice Chair; Michelle W. Bowman; Lael Brainard; James Bullard; Richard H. Clarida; Charles L. Evans; and Randal K. Quarles. Voting against the action were Esther L. George and Eric S. Rosengren, who preferred at this meeting to maintain the target range for the federal funds rate at 2-1/4 to 2-1/2 percent.
We discuss the draft legislation which was released late Friday last week, and which would outlaw cash payments above $10k under the guise of tax efficiency.
But as we discussed before, the real agenda is all about negative interest rates and extreme monetary policy, as prescribed by the https://www.imf.org/en/Publications/WP/Issues/2019/04/29/Enabling-Deep-Negative-Rates-A-Guide-46598
This represents a significant curtailment of civil liberties, and more. We have just 2 weeks to respond.
Was this even covered in the main-stream media?
Previous War On Cash Video:
https://www.adamseconomics.com/post/the-new-global-push-for-negative-nominal-interest-rates
We review the latest from the RBA – is their stance appropriate?
RBA Governor Philip Lowe spoke today, and there were some important points.
First, expect rates to be lower for longer. ” It is highly unlikely that we will be contemplating higher interest rates until we are confident that inflation will return to around the midpoint of the target range”.
Second, the RBA has more capacity to cut if required (we think they will).
Third, moving the 2-3% inflation target band is not something they would want (the Treasurer is currently reviewing the RBA’s mandate and target!). They do not want to “shift the goalposts”!
Here is the speech:
I would like to start by winding the clock back, not by three years, but instead by 40 years. It was 40 years ago that I started studying economics in high school in Wagga Wagga. I sat the 3 unit economics exam for the Higher School Certificate (HSC) in 1979. At that time, the standard exam question was in two parts: why did Australia have both high inflation and high unemployment and what should policy do about it? I recall writing numerous essays on this troubling topic.
I also recall learning about the Misery Index. For those of you whose memories don’t go back that far, this index is the sum of the unemployment rate and the inflation rate. Few people talk about this index these days, but I thought it would be useful to show it to you as background (Graph 1). As you can see, things were pretty miserable in the 1970s and 1980s. Today, though, at least according to this metric, they are not too bad. The Misery Index is now as low as it has been since the late 1960s. Today, we are living in a world of low and stable inflation and low unemployment. It is useful to remind ourselves of this sometimes.
So this means that today’s HSC students are likely to be writing about why inflation is so low at the same time that unemployment is also low. I hope that they are also being asked to write about how public policy should respond to low inflation and its close cousins of slow growth in nominal wages and household incomes.
These are important issues to be thinking about. Given this, I would like to use this opportunity to address two related questions that I am asked frequently.
The first of these is why is inflation so low globally and in Australia?
And the second is, is inflation targeting still appropriate in this low inflation world?
I will then draw on my answers to make some remarks about monetary policy here in Australia.
It is useful to start off with a couple of graphs.
The first is the average rate of inflation globally (Graph 2). The picture is pretty clear. Global inflation declined over the three decades to the early 2000s and has been low and stable for some time.
Low inflation has become the norm in most economies. This is evident in this next graph, which shows the share of advanced economies with a core inflation rate below 2 per cent and below 1 per cent (Graph 3). Currently, three-quarters of advanced economies have an inflation rate below 2 per cent, and one-third have an inflation rate below 1 per cent.
The obvious question is why this has happened?
There is no single answer. But there are three factors that, together, help explain what has happened. These are: the credibility of the current monetary frameworks; the continuing existence of spare capacity in parts of the global economy; and structural factors related to technology and globalisation.
I will say a few words about each of these.
First, the credibility of the monetary frameworks. One of the responses to the high inflation rates of the 1970s and 1980s was to put in place monetary frameworks with a strong focus on inflation control. In some countries, this took the form of rewriting the law to require the central bank to focus on just one thing: inflation. Many countries also adopted an inflation target, with monetary policy decisions being explained primarily in terms of inflation.
This increased focus on inflation has helped cement low inflation norms in our economies. Many people understand that if inflation were to pick up too much, the central bank would respond to make sure the pick-up was only temporary. This means that workers and firms can make their decisions on the basis that the rate of overall inflation will not be too different from the target rate. This has made the system less inflation prone than it once was.
The second explanation for low inflation is the continuing existence of spare capacity in parts of the global economy.
The existence of spare capacity was an important factor explaining low inflation in the aftermath of the global financial crisis. And today, it remains a factor in some countries, including here in Australia. But, on the surface, it is a less convincing explanation for low inflation in countries where unemployment rates are now at multi-decade lows. Based on conventional measures of capacity utilisation, these economies are operating close to their sustainable limits. One explanation for continuing low inflation in this environment is that the current rate of aggregate demand growth is simply not fast enough to put meaningful pressure on capacity. If so, stronger demand growth would be expected to see inflation pick up. Another possibility is that the unemployment rate, by itself, no longer provides a good guide to spare capacity, partly due to the flexibility of labour supply. I will come back to this idea in the discussion of inflation outcomes in Australia.
The third explanation is that globalisation and advances in technology have changed pricing dynamics. There are two main channels through which this appears to be happening. The first is by lowering the cost of production of many goods. And the second is by making markets more contestable and increasing competition. The main effect of these changes should be on the level of prices, rather than on the ongoing rate of inflation. But this level effect is playing out over many years, so it appears as persistently low inflation.
It is widely accepted that the entry into the global trading system of hundreds of millions of people with access to modern technology put downward pressure on the prices of manufactured goods. Reflecting this, goods prices in the advanced economies have barely increased over the past couple of decades (Graph 4). But the effects of globalisation and technology extend beyond this and into almost every corner of the economy, including the services sector.
In today’s globalised world, there are fewer and fewer services that can be thought of as truly non-traded. Many services can now be delivered by somebody in another country. Examples include: the preparation of architectural drawings, document design and publishing, customer service roles and these days many people in professional services work with team members located in other countries. In addition, many tasks, such as accounting and payroll, are being automated. All this has been made possible by technology and by globalisation.
The new global technology platforms have also revolutionised services such as retail, media and entertainment, and transformed how we communicate and search for information and compare prices.
These changes are having a material effect on pricing, with services price inflation lower than it once was. Many firms know that if they don’t keep their prices down, another firm somewhere in the world might undercut them. And many workers are concerned that if the cost of employing them is too high, relative to their productivity, their employer might look overseas or consider automation. And, more broadly, better price discovery keeps the competitive pressure on firms. The end result is a pervasive feeling of more competition. And more competition normally means lower prices.[1]
So these are the three important factors that are contributing to low inflation. None of them by themselves is sufficient to explain what is happening, but together they are having a powerful effect. The current high inflation rates in Argentina and Turkey remind us that globalisation and technology, by themselves, do not drive low inflation. The monetary framework clearly matters too. Weaknesses in that framework still result in high inflation.
This brings me to my second question: is inflation targeting still the appropriate monetary framework for most countries?
It is understandable that people are asking this question. Given the factors that I have just discussed, some commentators have argued that central banks will find it increasingly difficult to achieve their inflation targets. Some then go on to argue that central banks should just accept this, not fight it; perhaps they should shift the goal posts, or even adopt another monetary framework. A related argument is that the very low interest rates that have accompanied the pursuit of inflation targets are pushing up asset prices in an unsustainable way and sowing the seeds for damaging problems in the future.
You might, or might not, agree with these perspectives. Either way, it is reasonable to ask if we are on the right track: is inflation targeting still appropriate?
Before I address this question, I would like to push back against the idea that central banks simply can’t achieve their inflation targets. As we all know, some central banks have struggled to achieve their targets over a long period of time; Japan and the euro area are the obvious examples. But this is not a universal experience. Over recent times, inflation has been around target in Canada, Norway, Sweden and the United Kingdom. So the experience is mixed (Graph 5).
There is no single factor that explains this mixed experience. But countries that are operating nearer to full capacity are more likely to have inflation close to target. It also appears that if you have an extended period of very low inflation – as did Japan and the euro area – it is harder to get back to target as a deflationary mindset takes hold. It is also possible that demographics may be playing a role, although the evidence here is mixed.
Overall, these varying experiences do not support the idea that it has become impossible for central banks to achieve their targets.
Here in Australia, some have argued that a lower inflation target would be a good idea given the ongoing low rates of inflation; that we should adjust our formulation of 2–3 per cent, on average, over time. Lowering the target might have the short-run advantage of allowing us to say we have achieved our goal, but shifting the goalposts hardly seems a good way to build long-term credibility. Shifting the goal posts could also entrench a low inflation mindset.
More broadly, over recent years the international debate has gone in the other direction: that is, to argue for a higher, not lower, inflation target. The argument is that a higher rate of inflation – and thus a higher average level of interest rates – would promote economic welfare by providing more room to lower interest rates, without running up against the lower bound. This greater flexibility for monetary policy could stabilise the economy when it was hit with a negative shock. To be clear, I am not arguing for a higher inflation target, but rather acknowledging there are arguments in both directions.
This brings me back to the question: is inflation targeting still appropriate?
The short answer is yes, but it is important to be clear what this means in practice.
Inflation targeting can mean different things to different people. It comes in different shapes and sizes. Some versions require a central bank to focus on inflation alone and set monetary policy so that the forecast rate of inflation is equal to the target. But inflation targeting does not need to be rigid like this.
In my view, an inflation targeting regime should consist of the following four elements.
So these are the four elements that I see as important to an effective inflation-targeting regime.
We have all four elements in Australia. Our commitment to deliver an average inflation rate over time of 2 point something provides a strong nominal anchor. We have always viewed the inflation target in the wider context, reflecting the broad mandate for the RBA set out in the Reserve Bank Act 1959. That Act was passed 60 years ago and has stood the test of time. The RBA was also one of the earliest advocates of flexible inflation targeting – this is evident in our use of the words, ‘on average, over time’ when describing our target. We also place a heavy emphasis on explaining our decisions and their rationale to the community.
Our overall assessment is that Australia’s monetary policy framework has served the country well over the past three decades. The flexibility that has always been part of our regime has helped underpin a strong and stable economy and has helped Australia deal with some very large economic shocks. We are not inflation nutters. Rather, we are seeking to deliver low and stable inflation in a way that maximises the welfare of our society.
Over the nearly 30 years we have had the inflation target, inflation has averaged 2.4 per cent, very close to the midpoint. It has, however, been below this average over recent years and I will talk about this in a few moments.
Before I do so, it is important to note that we periodically review the formulation of the current target and examine alternative monetary frameworks, including at our annual conference last year.[2] We are also monitoring closely the discussions that are taking place in the academic community and in other central banks. In my view, the evidence does not support the idea that a change to our inflation target would deliver better economic outcomes than achieved by our current flexible inflation target. Some alternative frameworks would also be more difficult to implement and/or be harder to explain to the community. But it is important that we regularly examine the arguments.
I would now like to discuss recent inflation outcomes and monetary policy in Australia.
Like other countries, Australia has had low inflation over recent years. Over the past four years, headline inflation has mostly been below 2 per cent, although it has been slightly above that mark on a couple of occasions (Graph 6). In underlying terms, inflation has been below the band for three years.
Given this history, it is reasonable to ask why this happened and how the Reserve Bank Board has thought about it.
I will first focus on the period from late 2016 to late 2018. Through most of this period, gradual progress was being made in returning inflation to target and the unemployment rate was moving lower. Inflation was on a gentle upswing and the unemployment rate was coming down more quickly that we had expected. Reflecting this, in August 2017 the two-year ahead inflation forecast was 2½ per cent. Since then it has been lower than this, at 2–2¼ per cent.
Throughout this period, the Board discussed the case for seeking a faster and more assured return of inflation to around the midpoint of the target range. It was natural to be discussing this because having inflation around the midpoint of the target range allows more scope for surprises in either direction.
As you know, in the end the Board did not adjust interest rates through this period. It judged that seeking to achieve a faster return of inflation to the midpoint of the target range would have been accompanied by more rapid growth in debt, at a time when household balance sheets were already very extended. Our judgement was that, given the progress that was being made towards our goals, it was appropriate to use the flexibility in our inflation target to pursue a course that was more likely to be in the country’s long-term interest. We could have generated a bit more inflation, but we would have had faster growth in household debt as well.
I acknowledge that others might see this trade-off differently. But given the unemployment rate was coming down and inflation had lifted from its trough, we did not see a strong case for monetary easing.
Towards the end of last year, that assessment began to shift. Inflation was turning out to be lower than we had earlier expected and our forecasts for inflation were being marked down. There are a few reasons for this, but the one I want to highlight today is the flexibility of labour supply, as this links back to my earlier discussion of the reasons for low inflation globally.
When we prepared our forecasts in mid 2017, we did so on the basis that the share of the adult population participating in the labour market (the participation rate) would remain steady over the next couple of years (Graph 7). At the time, this was considered a reasonable forecast: while we expected some increase in participation from an encouraged worker effect because of solid employment growth, we thought this would be offset by the ageing of the population.
Since then, things have turned out quite differently. Employment growth has been much stronger than expected and the participation rate has risen by 1½ percentage points, which is a large change over a fairly short period. Put simply, the strong demand for labour has been met by more labour supply.
It is useful to consider the following thought experiment. Suppose the participation rate had still risen materially, but by ¾ per cent, rather than 1½ per cent. All else constant, this would have meant the unemployment rate today would have been well below 5 per cent.
This flexibility of labour supply is a positive development and has meant that strong employment growth has not tested the economy’s supply capacity. More demand for workers has been met with more labour supply. This has contributed to the subdued wage outcomes over recent times, which in turn has contributed to the low inflation outcomes.
The more flexible supply side means that employment growth can be stronger without fears of overheating. At the same time, the unemployment rate that would put upward pressure on inflation is also lower than it once was.
As the evidence accumulated in support of these propositions, the outlook for monetary policy changed and the Board lowered the cash rate in June and July. In making these decisions the Board also recognised that the earlier concerns about the trajectory of household debt had lessened. The Board has also paid attention to the shift in the outlook for monetary policy globally.
These two recent reductions in the cash rate will support demand in the Australian economy. So too will recent tax cuts, higher commodity prices, some stabilisation in the housing market, ongoing investment in infrastructure and a lift in resource sector investment. We also need to remember that the underlying foundations of the Australian economy remain strong.
It remains to be seen if future growth in demand will be sufficient to put pressure on the economy’s supply capacity and lift inflation in a reasonable timeframe. It is certainly possible that this is the outcome. But if demand growth is not sufficient, the Board is prepared to provide additional support by easing monetary policy further. However, as I have discussed on other occasions, other arms of public policy could also play a role in this scenario.
Whether or not further monetary easing is needed, it is reasonable to expect an extended period of low interest rates. On current projections, it will be some time before inflation is comfortably back within the target range. The Board is strongly committed to making sure we get there and continuing to deliver an average rate of inflation of between 2 and 3 per cent. It is highly unlikely that we will be contemplating higher interest rates until we are confident that inflation will return to around the midpoint of the target range.
The minutes out today spelled out the slowing momentum in the economy, and the cuts in rates would help with spare capacity, but would not lift risks emanating from higher debt in the medium term. Cannot see how both can be true, when the focus appears to be on rekindling the housing market! And given the calls from the RBA for the Government to spend more to assist in stronger growth. The sums just do not add up!
Members commenced their discussion by noting that growth in the global economy had remained moderate over preceding months. Global trade and manufacturing activity had slowed over the preceding year. Trade tensions had remained elevated, although no new measures had been introduced since the previous meeting.
In China, recent indicators of economic activity suggested that growth had slowed since the March quarter. Growth in industrial production had fallen following a strong reading in March and the level of fixed asset investment had declined. Conditions in the Chinese property market had also softened and underlying demand conditions were expected to moderate over time, given the ageing of the population and a slowing in the rate of urbanisation. Over the preceding month, the Chinese authorities had introduced additional measures to support growth, including more favourable financing conditions for local governments investing in infrastructure projects.
In east Asia, the combination of weaker Chinese growth, the downturn in global semiconductor demand and the trade and technology disputes had weighed on trade, although new export orders suggested that conditions might be stabilising. The effect of the US–China trade dispute had not been even across the region. Some economies, such as Thailand and Vietnam, had seen strong growth in their exports to the United States, which reflected some diversion of trade that had previously been between the United States and China.
Growth in output in the United States had continued to be supported by strong growth in consumption, while growth in investment appeared to have slowed further. Members noted that capital goods orders had slowed and that the stimulus to investment from tax cuts had largely run its course. Growth in domestic demand in the euro area had been relatively resilient in the March quarter, but more recent data had been mixed. Growth in Japanese domestic demand had slowed in early 2019, partly as a result of spillovers from weak external demand conditions, but growth was likely to be supported in the near term by a pick-up in consumption growth in the lead-up to an increase in the consumption tax in October 2019.
Labour markets remained tight in the major advanced economies. Members noted that participation rates for people aged between 15 and 64 years had increased significantly in recent years and unemployment rates were at historically low levels. This suggested that there was relatively little spare capacity in these labour markets. Members noted that participation rates of people aged 65 years and over had also been increasing. Wages growth had picked up, but this had not yet been translated into stronger inflationary pressures and inflation remained below target in most advanced economies. Although inflation had been around target in the United States, some measures suggested US inflation had shifted lower more recently. The decline in oil prices, by around 15 per cent since their peak in mid May, would weigh on headline inflation globally in the near term.
Iron ore prices had increased by more than 25 per cent since the previous meeting and had more than doubled over the previous year. Chinese steel production had continued to grow strongly in recent months, despite slowing industrial activity in China. At the same time, there was limited spare capacity in the seaborne market to increase supply and inventories of iron ore at Chinese ports had been declining. Rising iron ore prices had underpinned a 3 per cent increase in the Australian terms of trade in the March quarter.
Members noted that the main domestic economic news over the previous month had been the release of the national accounts for the March quarter and updates on the labour and housing markets.
The national accounts reported that the domestic economy had grown by 0.4 per cent in the March quarter. Public demand had continued to support growth in the quarter, with public consumption boosted by the rollout of the National Disability Insurance Scheme and increased spending on the Pharmaceutical Benefits Scheme. Growth in public sector investment had been positive despite a decline in defence spending. Members noted that there was a strong pipeline of public infrastructure projects that could support activity for some time.
Private demand had contracted for the third consecutive quarter because there had been further falls in mining investment and housing construction. Consumption growth had remained subdued.
Growth in business investment had been weaker than expected in the March quarter. This was partly because it had taken longer than expected for liquefied natural gas (LNG) projects to reach final completion. However, investment in automation and other productive efficiencies had supported machinery & equipment investment in the mining sector. Non-mining business investment had continued to expand in the March quarter, supported by a further increase in non-residential construction, while non-mining machinery & equipment investment had fallen. Members observed that there had been some differences in the findings of surveys of business conditions. In the main, surveyed measures of business conditions had declined to around or a little above average levels. However, both the retail and transportation sectors had experienced well below-average conditions.
Exports had increased in the March quarter, primarily driven by growth in rural and service exports. The boost to meat exports in the quarter as a result of ongoing drought conditions leading to destocking had been larger than the subtraction from lower crop exports. Resource exports (excluding non-monetary gold) had fallen in the March quarter because of temporary supply disruptions. More recent data on trade and shipments suggested that iron ore and LNG exports had increased since the March quarter, while coal exports appeared to have fallen. Higher iron ore prices had supported overall export values and the trade surplus had increased to almost 3 per cent of GDP in the March quarter. The trade surplus was at its highest level, and the current account deficit at its lowest level, measured as a share of GDP, since the 1970s.
Consumption had grown by 1.8 per cent over the year to the March quarter, which was well below average. Members noted that, in per capita terms, consumption had been broadly flat. Growth in household spending on essential items had been relatively steady, while the level of spending on discretionary items had fallen in the March quarter. This weakness had been broadly based across the states and recent retail trade data suggested that discretionary spending had remained soft in the June quarter.
Members had a detailed discussion of the effects on price inflation in the retail trade sector of increased competition from foreign entrants and online retailers over the preceding decade or so. Members noted that the increase in the supply of retail items and lower retail prices in response to increased competition were positive developments for consumers, other things equal. Many retailers and wholesalers had also become more efficient in response to more intense competition, often using new technology (including in logistics), which had resulted in relatively rapid multifactor productivity growth in these sectors. Members noted that the adjustment in the retail sector had been protracted and had put downward pressure on inflation for some years. In the more recent period, the effects on prices of greater competition had been difficult to separate from the effects of the prevailing weak demand conditions.
Growth in household disposable income had increased in recent quarters, supported by growth in labour income, but had remained low in year-ended terms. Members noted that growth in labour income had been driven by strong employment growth and that growth in hourly earnings had remained subdued. New private sector enterprise bargaining agreements had incorporated slightly faster wages growth than agreements reached a year earlier. However, wages growth for workers on existing enterprise bargaining agreements had remained subdued, and there was little prospect of a near-term pick-up in public sector outcomes given the ongoing wage caps.
A small decline in growth in tax payments had also contributed to growth in household disposable income in the March quarter. By contrast, the income of unincorporated enterprises had remained weak, partly because of drought-related falls in farm incomes and the downturn in housing construction. Members noted that this weakness was likely to continue in the near term.
Dwelling investment had declined in the March quarter. Further falls were expected given the sharp decline in building approvals over the preceding year and a half. While the pipeline of construction work yet to be done in New South Wales and Victoria remained high, liaison contacts expected housing construction could drop off more sharply because pre-sales activity had been so weak.
Conditions in the established housing markets of Sydney and Melbourne had improved a little since the previous meeting. Housing prices had stabilised in June in these cities and auction clearance rates had picked up further, albeit still on low volumes. More generally, turnover in the housing market had remained low. Housing prices had continued to fall in Perth and Darwin.
Employment growth had remained strong, at 2.9 per cent over the year to May. Despite this, there was still spare capacity in the labour market. Some of the additional labour demand had been met by an increase in the participation rate, which had reached its highest level on record. Even so, forward-looking indicators, such as job advertisements and employment intentions, suggested that growth in employment would moderate over coming months. The unemployment rate had remained at 5.2 per cent in May and the underemployment rate had remained elevated.
In view of the fact the meeting was held in Darwin, members had a thorough discussion of economic conditions and future economic opportunities in the Northern Territory. They noted that the Northern Territory economy had experienced a significant cycle related to the construction and then completion of the INPEX LNG plant. The downturn in the mining cycle had had significant spillovers to other parts of the Northern Territory economy because, aside from the public sector, mining and construction are the largest industries in terms of gross value added. Employment had fallen in the Northern Territory over 2019 and this had been accompanied by large flows of people moving to other parts of the country. As a result, the unemployment rate for the Northern Territory had increased, but it remained lower than the national average. More generally, the Northern Territory had a relatively young population and high labour market participation rates. The decline in the Northern Territory population had also led to a significant decline in dwelling investment in the Northern Territory over recent years.
Members observed that the broad statistics on the labour market for the Northern Territory masked the relative disadvantage of the Indigenous population. The unemployment rate for Indigenous Australians on average was relatively high, and Indigenous Australians were less likely to complete school and more likely to experience poor health. These measures of Indigenous disadvantage were particularly acute in remote locations, where it is more difficult to deliver services.
Members noted that there were a number of opportunities for economic growth in the Northern Territory in the future, including tourism, agricultural exports (including live beef exports), the defence industry and mining. Higher mining investment in the Northern Territory in the future could come from some small-scale mining projects that had not yet reached final investment decision and the possibility of some onshore unconventional gas projects.
Members commenced their discussion of financial markets by noting the significant change in the expected path of monetary policy around the world, particularly in the United States. This change had reflected a combination of weaker-than-expected economic activity and inflation over recent months, as well as the downside risks from the trade and technology disputes between the United States and China.
Monetary policy in the United States had been unchanged in June, but the Federal Reserve had indicated that it was prepared to act to sustain the economic expansion. Members of the Federal Open Market Committee (FOMC) saw a stronger case to reduce the federal funds rate during 2019, in contrast with the earlier ‘patient’ stance as the FOMC had awaited further data. Market pricing had moved to imply an expectation that the federal funds rate would decline by 100 basis points over the following year, compared with 50 basis points a month earlier.
In other major economies, the European Central Bank had indicated that it was prepared to add more monetary stimulus if the outlook for growth and inflation did not improve, including by expanding its bond-buying program. The Bank of Japan had intimated that it would allow bond yields to move below the lower end of its ‘yield curve control’ target and reiterated that there was scope to ease monetary policy further if needed. And in China, market participants expected the People’s Bank of China to ease monetary policy further in the period ahead.
As expectations for monetary policy easing had firmed over the course of this year, government bond yields had declined further in major markets, to a record low in Germany and further into negative territory in Japan. In the United States, lower bond yields reflected lower expected real policy rates for an extended period, as well as persistently low inflation and term premia. Yields on 10-year Australian government bonds had reached a historical low of 1.3 per cent, with yields remaining around 70 basis points below US treasury bond yields of similar maturity. Compensation for risk on corporate bonds globally remained compressed, as market participants judged that policy easing would support growth in economic activity and profits. Members noted that, as a result, the cost of funds for corporations remained low, including in Australia.
Equity prices had increased in major markets over the preceding month, to a record high level in the United States, despite prominent downside risks. Higher equity prices owed primarily to a lowering of discount rates, reflecting the expected easing of monetary policies, whereas the outlook for corporate earnings had been little changed. Recent movements in equity prices in Australia had broadly followed international trends, with increases in equity prices in all main sectors over the preceding month. Members noted that analysts’ forecasts of earnings of Australian non-resource companies had declined over the course of the past year, consistent with broader surveys of business conditions.
Members noted that bank liquidity conditions in China had remained accommodative overall. However, the solvency and liquidity of small banks (which account for one-quarter of banking assets) had been attracting more scrutiny from both investors and the authorities after a period of rapid asset growth, amid wider financial stability concerns.
In foreign exchange markets, the US dollar had remained around multi-year highs on a trade-weighted basis, although it had depreciated somewhat in the weeks leading up to the meeting as US bond yields had declined relative to those in other major economies. The euro had remained within the relatively narrow range of the preceding few years on a trade-weighted basis, while the yen had broadly appreciated over recent months. The Australian dollar had been largely unchanged following the decision to lower the cash rate in June. Nevertheless, having depreciated by about 3 per cent in TWI terms since late 2018, the Australian dollar was around its lows of recent years, with the effect of the decline in Australian bond yields relative to other major markets over that period partly offset by the unexpected strength in commodity prices.
In Australia, monthly housing credit growth had remained broadly stable in recent months, particularly for lending for owner-occupation. Aggregate housing credit had been growing at an annualised rate of around 3 per cent, with much of the decline in the rate of growth over the preceding year driven by weaker demand for finance associated with the correction in the housing market. Loan approvals by both owner-occupiers and investors had continued to decline in May. However, an easing in the loan serviceability interest-rate floor was likely to see a boost in borrowing capacity for many new borrowers, which would be in addition to the positive effect on the cash flow of the household sector overall following the reduction in the cash rate at the previous meeting.
The three-month bank bill swap rate (BBSW) had declined further over the preceding month. Accordingly, the increase in the spreads of BBSW and other short-term money market rates to the overnight indexed swap rate in 2018 had been fully unwound. Wholesale funding costs (which affect two-thirds of banks’ debt funding) had also declined in line with the cash rate. As a result, the major banks’ debt funding costs had reached a historic low.
Members noted that the favourable financing conditions for non-financial corporations had supported corporate bond issuance. Although business credit growth had declined over recent months, growth in total business debt had remained little changed. Meanwhile, yields on residential mortgage-backed securities had also been at low levels and issuance by non-banks in this market had increased significantly in the June quarter, to levels not seen since prior to the global financial crisis.
Members noted that most lenders had passed on the 25 basis points reduction in the cash rate in June to mortgage rates. Business borrowing rates had declined in line with the decline in BBSW. Members also noted that the reduction in the cash rate had been passed through to many retail deposit rates, although some of these rates were already very low.
Market pricing implied that further monetary policy easing was expected following recent data and the Bank’s communication since the previous meeting. A 25 basis points reduction in the cash rate had been fully priced in by August 2019, with a further easing expected by the end of the year.
Considerations for Monetary Policy
Members observed that the outlook for the global economy remained reasonable, although the risks from the international trade and technology disputes remained high. Growth in trade had remained weak and there had been further signs that heightened uncertainty was affecting investment decisions. Despite tight labour markets and rising wages growth, inflation had generally remained low in the advanced economies. Both the trade-related downside risks to global growth and ongoing subdued inflation had spurred an increased expectation that major central banks would ease monetary policy. This had reinforced already very accommodative conditions in global financial markets.
In considering the policy decision, members discussed the recent data on output and the labour market. On the former, GDP growth had been well below trend over the year to the March quarter. Despite strong growth in employment, growth in household disposable income had remained low and this had contributed to low growth in consumption. Members noted the near-term prospects for a lift in income growth and the contribution of the low and middle income tax offset. Higher growth in disposable income was expected to support consumption, although the outlook for consumption remained uncertain. Accommodative monetary policy, strong public demand, a renewed expansion in the resources sector and growth in exports were also expected to support a return of GDP growth to trend over coming years.
Members observed that employment growth continued to outpace growth in the working-age population. However, most of the strength in labour demand over preceding months had been met by an increase in participation, which had risen to a record high level, rather than a decline in the unemployment rate. Although there had been a modest pick-up in wages growth in the private sector, wages growth had remained low overall. In combination, these factors suggested that spare capacity was likely to remain in the labour market for some time.
Declining housing prices had also contributed to low growth in consumption, although there were signs that conditions in some housing markets, notably in Sydney and Melbourne, had stabilised. Members noted that mortgage rates were at record lows and that there was strong competition for borrowers of high credit quality. However, demand for credit by investors continued to be subdued and credit conditions for small and medium-sized businesses remained tight.
In assessing the outlook for inflation, members agreed that further improvements in the labour market would be required for wages growth to increase materially. As assessed at the previous meeting, members agreed that the Australian economy could sustain a lower rate of unemployment, while achieving inflation consistent with the target. In light of this, the recent run of data and the lower level of interest rates resulting from the decision taken at the previous meeting, the case for a further reduction in the cash rate was considered.
Members recognised that, in the current environment, the main channels through which lower interest rates would support the economy were a lower value of the exchange rate than otherwise would be the case and lower required interest payments on borrowing, which would free up cash for other expenditure by households and businesses.
Members judged that a further reduction in the level of interest rates would support the necessary growth in employment and incomes, and promote stronger overall economic conditions, which would in turn support a gradual increase in underlying inflation. Members also judged that the extent of spare capacity in the economy, and the likely pace at which it would be absorbed, meant that a decline in interest rates was unlikely to encourage an unwelcome material pick-up in borrowing by households that would add to medium-term risks in the economy. Members recognised the uneven effect of lower interest rates on different households.
Taking into account all the available information, the Board decided that it was appropriate to lower the cash rate by 25 basis points. This decision, together with the reduction in the cash rate decided at the previous meeting, would assist in reducing spare capacity in the economy and making faster progress in reducing the unemployment rate. Lower interest rates would provide more Australians with jobs and assist with achieving more assured progress towards the inflation target. The Board would continue to monitor developments in the labour market closely and adjust monetary policy if needed to support sustainable growth in the economy and the achievement of the inflation target over time.
