On Australia’s Rate Cut

This is going to be a daily commentary that doesn’t rely on recent reporting of events. I am going to pen this based on my macro view about Australia, disregarding the recent evolution in Australia’s economy.

Australia has been in an economic boom for two decades. The last recession that Australia had occurred in the early 1990s. This is a remarkable run of nearly a quarter-century. And I think other countries that have not had nearly as long a run, should learn from this example. The question goes to what exactly we can learn.

The question we should be asking then is whether Australia represents the last great example of “The Great Moderation” or whether Australia’s remarkable run is the result of some kind of imbalance that is destined to be corrected. For example, if Australia is the last great example of the Great Moderation, then we should all try to emulate the facets of Australian macro policy that has created such a lasting boom. On the other hand, if Australia has built up a lot of macro imbalances, then we should be asking how those imbalances will be eradicated.

Australia just cut its policy rate to 2.75%, the lowest on record. That puts Australia into the same camp as all of the other major economic areas, where policy rates are all at record low levels. If you believe that Australia has used macro to navigate the last quarter-century well, then this move to join the others is just another macro move within a longer Great Moderation to smooth out the business cycle. However, if like me, you believe that this interest rate cut represents a tacit admission that Australia has been infected by the debt deflationary bug that every other major economy has caught, it is an ominous sign.

I think I have tipped my hand as to where I come out here. So I will be a bit more explicit. Steve Keen is right, if early. The Australian miracle relies on an accumulation of household debt, which is centered in the mortgage sector. This is Australia’s Achilles’ heel. If the housing market cracks, then you will likely get an economic downdraft like the ones we have seen elsewhere where growth has relied on mortgage debt accumulation, Denmark, the Netherlands, the United States, the United Kingdom, Spain, Ireland, etc. Australia is one of a few economies that has yet to feel the full force of a housing downdraft in this economic crisis. The other notable countries are France and Canada.

Now, just to argue the other side for a second, the point here is that countercyclical macro policy can help countries avoid recession – or at least attenuate the severity of recession. And that’s how monetary and fiscal stimulus are used during a recession. The first-choice policy tool in major industrialized countries for monetary policy is adjusting interest-rate policy by changing the policy rate according to how well the economy is doing. And so Australia is doing that. The country has another 11 25-basis point cuts left before it runs out of room on this front. So to the degree you think the global economy will improve, it suggests Australia could ride this one out on the back of deft countercyclical policy choices.

I see the situation somewhat differently. I wouldn’t say countercyclical policy is wrong per se. However, I would say that the use of countercyclical policy has led policy makers to turn a blind eye to macro credit and debt aggregates. Across the industrialized world, credit growth has so significantly outpaced economic growth that one has to wonder how much longer this can last. In fact, in many countries with popped housing bubbles, it didn’t last. They are in balance sheet recessions. Others like the US and the UK are trying to extricate themselves from these balance sheet recessions, ostensibly on the back of a further household releveraging. Meanwhile, Canada and Australia have successfully escaped the deleveraging that has led to economic malaise elsewhere. I believe this is a dangerous situation, especially when a large percentage of economy watchers continue to ignore the build-up of household debt.

If I had to guess, based on the commodity cycle and external economic events that impinge on Australia, I would say that I expect rates to continue to fall. How far will they fall? That depends on how much the housing sector is impacted by the economic slowdown in Australia. To me, with the uptrend in the commodities cycle weakened, Australia is now one big housing bet. If mortgage credit growth falters with growth, I would expect more rapid rate cuts going forward. And at some point, the Reserve Bank of Australia could run out of room to cut. If it does, it will have to use the other second-choice monetary policy tools that other central banks are using. And then we will know that the Great Moderation is well and truly over.