‘Way down we go’: Cash rate hits a new record low

RBA rate cuts are like buses, you wait for ages for the first one to arrive only for the next one to turn up right afterwards. More signs of housing market stabilisation. Another record trade surplus. Tax relief is on its way. Another ceasefire in the US-China trade war but global manufacturing continues to suffer.

What I’ve been following in Australia . . .

What happened:

At its meeting on 2 July, the RBA Board decided to cut the cash rate by 25bp to a new record low of one per cent, meaning that the previous record low had stood for just one month. According to the accompanying statement the easing of monetary policy ‘will support employment growth and provide greater confidence that inflation will be consistent with the medium-term target’. The Board also pledged to ‘continue to monitor developments in the labour market closely and adjust monetary policy if needed.’

In a speech given at a dinner in Darwin following the rate cut, Governor Lowe argued that the ‘two cuts in interest rates the Board has delivered recently will make an important contribution to putting us on a better path and winding back spare capacity.’ He also pointed to what he saw as four positive factors that he thought would help the Australian economy:

• Borrowing costs for ‘almost all borrowers are now the lowest they have ever been’, reflecting both low official rates and low credit spreads.
• High terms of trade will help encourage a rise in mining investment ‘over the next few years’ with the RBA expecting ‘a solid upswing in the resources sector.’
• A lower exchange rate is helping support the traded sector of the economy.
• The RBA is sticking to its forecast of ‘stronger growth in household disposable income over the next couple of years, partly due to the expected implementation of the low and middle income tax offset.’

But Lowe also flagged the impact of the US-China trade and technology disputes in terms of ‘less international trade and a weakening trend in investment globally’, noting that investors now expected a substantial reduction in the US policy rate and for official rates in Europe and Japan to head deeper into negative territory, producing ‘quite a different world from the one we were facing earlier in the year.’ While the RBA’s ‘central scenario for both the global and Australian economies is still for reasonable growth, low unemployment and low and stable inflation’, Lowe concluded his speech by noting that the central bank would be ‘closely monitoring how things evolve over coming months’ and that ‘the Board is prepared to adjust interest rates again if needed’.

Why it matters:

While not quite the sure thing that June’s move was, a cut in July was still widely expected by markets and most economists (see last week’s note). As a result, the decision was not a surprise, even if finding Australia’s policy rate down at one per cent is itself a rather eyebrow-raising outcome. Note also that this was the first back-to-back rate cut since the RBA cut the cash rate by 50bp in May 2012 and then followed up with a 25bp cut the following month.

We are now deep into the third monetary policy easing cycle of this century, with this one looking quite different to its two predecessors in terms both of duration and the terminal level of the cash rate:

• The first easing cycle – in response to the global slowdown accompanying the dot-com crash – started in February 2001 and ended in December 2001 after delivering a cumulative 200bp of easing that left the cash rate at 4.25 per cent.
• The second cycle was triggered by the GFC, lasted from September 2008 to April 2009, delivered 425bb of easing and left the cash rate at three per cent.
• The current cycle started all the way back in November 2011 and to date has delivered 375bp of easing and a cash rate at one per cent (for now).

What happens next?

Before this week’s move, markets had anticipated more policy easing, with the cash rate expected to fall to 0.75 per cent before the year is over, and possibly drop to 0.5 per cent in 2020, and those expectations seem to be largely intact following the rate cut.

Of course, the RBA will be hoping to avoid this kind of outcome, but that depends on how the economy reacts to the current rate cuts (remember that the standard assumption is that there is a one to two year lag before the maximum impact of a rate cut is felt), the response of the economy to the fiscal stimulus that will now be delivered over the second half of this year through the government’s tax package, and the uplift from continued infrastructure investment. Then there is potential impact of developments in the global economy to consider. As Lowe flagged in his speech, the RBA will be tracking events closely over the next few months, with the uncertain external environment such that the RBA board ‘is prepared to adjust interest rates again if needed.’

Last week, we noted that one scenario prompting a fair bit of speculation is what happens under these circumstances if the economy were to get hit by a serious adverse shock, and more specifically, whether that would prompt the RBA to adopt unconventional monetary policy measures such as Quantitative Easing.

We’re not there yet, but just the discussion itself is another powerful reminder that we’ve turned out to be much less immune to the kind of ‘lowflation’ maladies that have afflicted other developed economies over the past decade than we once assumed.

What happened:

According to CoreLogic, Australian national house prices fell by just 0.2 per cent over the month in June, the smallest decline since March 2018. Combined capital cities prices were down just 0.1 per cent in month on month terms, while prices in Sydney (+0.1 per cent) and Melbourne (+0.2 per cent) increased in June. Sydney house prices hadn’t seen a monthly increase since July 2017 and Melbourne prices since November 2017.

Prices were also up in Hobart (+0.2 per cent) but were down in all other capital cities, with the largest falls in Darwin and Canberra (-0.9 per cent) and Perth (-0.7 per cent).

Relative to their previous peak, national dwelling prices are now down 8.4 per cent, capital cities prices are down 10.2 per cent, prices in Melbourne are down 10.9 per cent and prices in Sydney are down 14.9 per cent. Darwin remains the ‘champion’ in terms of the largest drop, however, with prices 30.1 per cent below their peak.

Why it matters:

The overall monthly rate of house price decline continued to ease again in June, providing more ammunition for the case that the housing market may be approaching stabilisation (although it’s worth remembering that outside Sydney and Melbourne, housing market conditions continued to look soft). CoreLogic also pointed to other positive indicators supporting this relatively positive prognosis, including auction clearance rates that were above 60 per cent in Sydney and Melbourne through June (up from rates in the low 40 per cent range in late 2018) and a levelling out of settled sales activity. If current trends are sustained, that should provide some useful relief to household balance sheets and help buttress household confidence.

What happened:

Australia recorded a new record trade surplus of $5.7 billion (seasonally adjusted) in May, up roughly 19 per cent on April’s $4.8 billion outcome. Exports were up more than 16 per cent over the year with a particularly strong performance by resources, while annual import growth was much more subdued at less than three per cent.

May’s numbers reflected another strong contribution from exports of resources and minerals.

Exports of iron ore did particularly well, thanks to a surge in the iron ore price which this week hit a five-year high, pushing above US$125/t. High prices mainly reflect a combination of supply disruptions after the disastrous collapse of the Brumadinho tailings dam in January this year, which has produced a significant and long-lasting disruption to Brazilian iron ore exports. More recent weather-related disruption to Australian supply has then further added to the squeeze on seaborne iron ore1. At the same time, China’s demand for steel, given a boost by Beijing’s stimulus measures that have helped support the construction sector, has also been a contributory factor.

Why it matters:

The resource sector has been one of the bright spots in Australia’s economic story this year, with high commodity prices boosting the terms of trade, company profits and the government’s coffers as well as delivering a series of record monthly trade surpluses. In recent comments (see above), RBA Governor Lowe noted that the RBA expects ‘a solid upswing in the resources sector’ over the next few years, citing it as one of four positive factors for the Australian economic outlook.

High commodity prices and a rapidly shrinking current account deficit also help place a floor under the Australian dollar, which at the time of writing was back above US$0.702. That complicates one of the channels for the lower cash rate to deliver stimulus to the economy.

The latest Resources and Energy Quarterly (REQ) from the Department of Industry captures the current strength in commodity prices in the form of a significant change to the forecast for Australian resource exports. Previous REQs had predicted that our commodity export earnings would peak in 2018–19: in the March 2019 REQ, for example, the forecast was for record earnings of almost $278 billion in 2018–19 but then a decline in export values in subsequent years. That 2018–19 forecast has been revised down a bit (the new estimate is $275 billion), but the June 2019 REQ now sees the peak in resource and energy commodity export earnings arriving in 2019–20, with the forecast revised up by $12.9 billion to $285 billion.

Again, a key factor behind the new forecast profile is the surge in iron ore prices, with the REQ predicting that the supply disruptions described above mean that the seaborne iron ore market will stay tight, keeping prices elevated, until at least 20213. As a result, the June 2019 REQ now sees the price of iron ore averaging US$80/t in 2019, up from US$61/t in 2018 and revised up from a forecast of US$67/t in the March REQ. Prices are then forecast to fall back to average US$61.40/t next year and US$57/t by 2012. Iron ore export earnings are predicted to rise from $61 billion in 2017-18 to an estimated $75 billion in 2018-19, which would be the second highest level on record. They are then forecast to rise again to $79 billion in 2019-20 before declining to $65 billion the following year.

Finally, also worth highlighting is the June’s REQ forecast that gold will overtake thermal coal as Australia’s fourth largest export commodity in 2019–20. While the value of thermal coal export earnings is estimated to have hit a record high of $26 billion in 2018-19, the REQ predicts that annual average spot prices will fall from US$105/t last year to US$83/t this year and US$75/t in 2020 as the expansion in global supply outpaces demand. As a result, Australian export values are forecast to fall to $21 billion in 2019-20 and to drop below $19 billion in 2020-21. In this context, the REQ also notes that China’s demand for thermal coal imports has been influenced by swings in policy drivers including enhanced quality testing, which led to delays at several ports, and a pickup in hydro and nuclear power generation which has displaced some coal-fired power generation. Despite a sharp reduction in Australian exports to China earlier this year, however, Australian exporters have managed to shift sales to South Korea, Taiwan and Vietnam.

What happened:

Retail turnover rose 0.1 per cent in May (seasonally adjusted), following a 0.1 per cent decline in April. Consensus expectations had been for a 0.2 per cent monthly increase.

Annual growth dipped to 2.4 per cent in May, the slowest pace of increase since January 2018. According to the ABS, Cafes, restaurant and takeaway food services, Household goods retailing, and Other retailing all saw monthly increases in May, while Food retailing, Department stores and Clothing, footwear and personal accessory retailing all experienced declines.

By State, there were monthly increases in Victoria, South Australia, the ACT and the Northern Territory and falls everywhere else.

Why it matters:

Subdued consumer spending is one of the main areas of weakness in Australia’s current economic performance and this month’s retail trade numbers provided further evidence that the second quarter is likely to have delivered another soft consumption result.

What happened:

The government’s $158 billion tax package looked set to pass parliament at the time of writing.

The new plan builds on the government’s already legislated Personal Income Tax Plan that was set out in Budget 2018-19, so it’s useful to begin with a quick recap of what that earlier plan has already locked in:

• A new low and middle income tax offset (LMITO) to supplement the existing low income tax offset (LITO). The LMITO provided tax relief up to a maximum of $530 for the 2018-19, 2019-20, 2020-21 and 2021-22 income years.
• With effect from last July (July 2018), the top threshold of the 32.5 per cent tax bracket was increased from $87,000 to $90,000.
• With effect from July 2022, the top threshold of the 32.5 per cent bracket will be increased again to $120,000.
• Also with effect from July 2022, the top threshold of the 19 per cent bracket will be increased from $37,000 to $41,000, while the LITO will be increased from $445 to $645.
• From July 2024 the 37 per cent income bracket will effectively be abolished, with the top threshold of the 32.5 per cent bracket increasing from $120,000 to $200,000.

Budget 2018-19 estimated that these changes would reduce tax receipts by $13.4 billion over the forward estimates. Budget 2019-20 then proposed several new measures that build on those earlier measures:

• From the 2018-19 income year, additional tax support for low- and middle-income taxpayers through an increase to the LMITO that will boost the maximum tax relief available from $530 to $1,080. As before, those increases will apply for 2018-19 and the next three income years.
• From July 2022 the top threshold of the 19 per cent tax bracket will now increase from the $41,000 legislated in Budget 2018-19 to $45,000 and the maximum amount of the LITO will increase from $645 to $700.
• From July 2024, the 32.5 per cent tax rate will be lowered to 30 per cent for taxable incomes between $45,000 and $200,000. That will leave Australia with just three tax rates: a 19 per cent tax rate applying to incomes between $18,201 and $45,000; a 30 per cent tax rate applying to incomes between $45,001 and $200,000, and a top tax rate of 45 per cent applying to incomes over $200,000.

The estimated impact of these new changes on government revenues is a $158 billion decline in receipts by 2029-30 and a more modest $20 billion decline by 2022-23. The bulk of the impact on government revenues is incurred from 2023-24 onwards, with the largest contribution coming from lowering the 32.5 per cent rate to 30 per cent from 2024-25.

Why it matters:

With most of the planned changes to the tax system scheduled to take place from July 2022 onwards, the immediate impact of the government’s tax measures will be felt through the fiscal stimulus provided by the increase in the LMITO.

Budget estimates suggest that the tax offset will benefit more than 10 million taxpayers, with about 4.5 million taxpayers projected to receive the full $1,080 reduction in tax for 2018-19 and the balance receiving a payment ranging between $255 and $1,080. Based on data from the Parliamentary Budget Office, the 2019-20 budget measures will lower revenues by about $3.45 billion while the 2018-19 measures they build upon will lower revenues by about $4.25 billion, delivering a total of about $7.7 billion in stimulus. That would be equivalent to around 0.6 per cent of annual household disposable income or, according to estimates by CBA economists, equivalent to two 25bp interest rate cuts.

With households suffering from subdued growth in disposable income plus balance sheet stresses arising from falling house prices against a backdrop of high debt, consumer spending has been squeezed. This in turn has dragged down overall economic growth. In this context, tax relief should provide some needed support to household budgets and some useful stimulus to the economy. Estimates based on the experience of the support offered by the Rudd government in response to the GFC suggest that the stimulus could trigger an appreciable bounce in retail spending.

Fiscal stimulus will also be welcomed by the RBA, which has been making the case repeatedly for fiscal policy to work alongside monetary policy in supporting the economy.

What about the longer-term impact of the tax package? The ultimate destination of a simpler and flatter income tax structure that is also more in line with the level of corporation tax certainly has some attractive features. The critical complication here is that the final changes to deliver this outcome won’t be implemented until after 2024-25 and it’s extremely difficult to know what the state of the economy and of the overall fiscal position, and hence budgetary capacities and priorities, will look like that far out. Experience has shown that budget projections within the forecast horizon of the forward estimates can be subject to significant revisions. It’s therefore difficult to have confidence in projections that go much further into the future.

. . . and what I’ve been following in the global economy

What happened:

Presidents Donald Trump and Xi Jinping agreed to resume US-China trade talks after meeting on the sidelines of the G20 in Osaka. The US side has reportedly agreed to refrain from introducing any new tariffs on imports from China and to ease existing restrictions on Huawei (a move which has sparked some criticism back in Washington, serving as a reminder that the current US-China showdown is not just a product of the current US president) while China has agreed to make new purchases of US farm products.

Why it matters:

The on-again, off-again trade negotiations between Washington and Beijing had broken down in May after the United States accused China of reneging on previous commitments made during the talks, prompting US President Trump to threaten to extend tariffs from the US$250 billion of Chinese imports to the United States already targeted by Washington to the remaining US$300 billion. The United States has also placed China’s Huawei on a blacklist that effectively prevents US companies from doing business it.

The good news here is that the Osaka meeting postpones any further extension in tariffs to a greater share of bilateral trade, prevents a potentially dangerous escalation in the trade war and provides some breathing room for both sides and for nervous financial markets.

Unfortunately, in the absence of a formal agreement (and maybe even then – see the recent US-Mexico trade spat), trade policy uncertainty will continue to be a risk for the global economic outlook. Existing tariffs will stay in place and no deadline has been set for the two sides to reach a deal: according to President Trump, ‘I am in no hurry, but things look very good!’

Meanwhile, other trade disputes rumble on: on Monday this week the US Trade Representative’s office published a list of US$4 billion of EU goods that it could target as part of the current Boeing-Airbus dispute. And the uncertainty created by the US-China dispute itself also continues to reshape the global economy: this recent report from Nikkei claims that global consumer electronics firms including HP, Dell, Microsoft and Amazon are all looking to shift ‘substantial production capacity’ out of China, while other firms including Google, Sony and Nintendo are also looking at relocating some of their manufacturing.

What happened:

The latest global PMI survey remained at 51.2 in June, a three-year low. The global manufacturing PMI fell to 49.4 in the same month, indicating that a majority of firms were reporting falling output. Of the 30 nations covered by the indicator, 18 signalled contractions including China, Japan, Germany, the UK, Taiwan and South Korea, while in the United States conditions remained close to stagnant. Services continue to be relatively more resilient, with the services PMI ticking up in June to 51.9, although that’s still one of the weakest readings seen over the past three years.

Why it matters:

The global PMI result is consistent with global GDP growing at an annual pace of approximately 1.8 per cent (at market prices) in the second quarter, down from 2.4 per cent in the first quarter. That global slowdown has been led by continued weakness in manufacturing; June’s manufacturing PMI reading was the lowest in almost seven years and marks the first time that the index has posted back-to-back readings of below 50 since the second half of 2012. Weakness in trade and investment, likely stoked by high levels of trade policy uncertainty, is serving as a significant headwind for the manufacturing sector. Services have been more resilient to date, supported by low levels of unemployment, decent wage growth and a structural shift in the composition of consumption. But with a significant overlap between trade, manufacturing and services, there are also signs that some of the weakness in manufacturing is spilling over into the services sector.

What happened:

The current US economic expansion is now officially that country’s longest on record4 , racking up 121 months (although still well behind Australia’s 111 quarters).

Why it matters:

Along with an economic expansion that is now longer than the previously record-breaking 120-month expansion between 1991 and 2001, President Trump can also boast of an economy that is currently enjoying its longest stretch of monthly job gains (104 months) and its lowest unemployment rate since 1969. To the extent that economic outcomes help determine political ones, this is all good news for the incumbent.

Consistent with the global pattern of slower growth post-GFC, the pace of growth in the current expansion has been slower than in previous ones, with the economy only growing at an average annual rate of 2.3 per cent compared to a growth rate of 3.6 per cent during the 1990s and a 4.2 per cent rate in the 1980s. As a result, the cumulative increase in GDP to date is only about half the sized of the increase delivered by the 1990s expansion: 20 per cent versus 41 per cent.

Meanwhile, US share markets closed at record highs on 3 July before the 4 July public holiday. The prospect of lower interest rates from the Fed (which also saw the yield on 10-year US Treasuries dip below 1.95 per cent for the first time in three years) and from other central banks across the world economy has buoyed market spirits.

President Trump’s latest two nominees for the Fed board seem to be intended to reinforce the current dovish tendency at the US central bank.

What I’ve been reading: articles and essays

ANZ on Australia’s exposure to the US-China trade war.

The RBA’s July 2019 chart pack.

The Grattan Institute argues that it is premature to pass Stage 3 of the government’s income tax cuts. 

The BIS has published its 2019 annual economic report. It got a bit of attention here in Australia because of the concluding plea for a more balanced policy mix and the claim that there are diminishing returns and costs in relying too much on monetary policy. With its calls for targeted fiscal expansions to support the economy, especially ‘by boosting well-chosen infrastructure investments’ and its argument that the only way to raise long-term growth on a sustainable basis is to implement structural reforms, it echoes recent commentary from the RBA making the case for fiscal policy and structural reform to take some of the load off monetary policy in supporting growth. The report also includes an interesting chapter on big tech in finance which argues that the entry of large technology firms such as Alibaba, Amazon, Facebook and Google into financial services offers the promise of big gains in efficiency, albeit at the possible cost of creating new and complex trade-offs between financial stability, competition and data protection.

Related, will digital currencies create a new kind of currency area?

The FT on the EU-Mercosur trade deal announced last Friday during the G20 meeting in Osaka, which after 20 years of talks will create a market more than 700 million people covering close to a quarter of global GDP. Note that the agreement still awaits ratification.

Also from the FT, a big read on weaponising the US dollar.

The money and banking blog reviews the case for strengthening automatic fiscal stabilisers as a response to limited scope for conventional monetary policy easing. It likes the idea but worries about the ability of US policymakers to implement it given that the US budget ‘already is on an unsustainable path.’ The blog post cites this report from Brookings which makes the case for creating automatic fiscal tools to deliver fiscal stimulus ‘in a timely, targeted, and temporary way.’ Alternatively, you can listen to one of the authors talk about some of the ideas here.

Brad Setser argues that China under Xi has deglobalized more than the United States under Trump.

Has China passed peak coal?

The Economist magazine provides a briefing on America and Iran runs with the tagline ‘An unwanted war is not necessarily an unlikely one’.

In the same edition, the Free exchange column argues that the global economy is on a knife-edge, hostage to the risk of policy mistakes by both politicians and central bankers.

Timothy Taylor (the Conversable Economist) looks at alligators, kangaroos and how markets can be a powerful tool for wildlife management.

1 The Department of Industry’s latest forecasts (discussed below) see the volume of Australian exports of iron ore falling from 848 Mt in 2018 to 806 Mt this year. Global seaborne iron ore supply is forecast to decline by about four per cent this year, with Vale’s production expected to recover only gradually over the next three years.

2 Expectations of US Fed rate cuts are also at work here.

3 The 2019-20 forecast also reflects the weaker outlook for the Australian dollar: in the May 2019 REQ the dollar was forecast at US$0.73 in 2019 and US$0.75 in 2020. The June REQ has the dollar at US$0.72 across both years.

4 Or at least since 1854.