Interest rates: More of the same?

Chinese authorities have calmed market fears of a liquidity squeeze but will there be further disruptions? AAP

Recent liquidity fears and resulting international market volatility has put the spotlight on global monetary policy and the role of central banks - including Australia.

China’s attempts to re-balance its economy by reining in credit and imposing tougher financial rules has led to a temporary spike in the interbank rate as financial institutions are scrambling for liquidity.

Following the Shanghai stock index’s worst one-day loss in nearly four years last week, the big question is whether China’s authorities will be able to engineer a soft landing or whether Chinese markets, and the economy, will experience further severe disruptions.

Bond markets have been spooked by hints from the US Federal Reserve that it may taper off its quantitative easing program (known as QE3) in early 2014. This is fundamentally good news, as it implies that the Fed sees the US economy on the road to recovery. However, the market’s reaction reveals how addicted investors have become to cheap credit.

In Europe there has been no progress towards a cooperative resolution of the Euro crisis. Cross-country imbalances persist, banks are still under-capitalised, and the fiscal outlook is dire as many Euro countries are flirting with recession.

In Australia, first quarter GDP data point to a slight reduction in the economy’s growth rate, largely due to a fall in investment, both public and private. The continued depreciation of the Australian dollar should help to relieve the pressure on the exporting sector but the dollar may need to fall further to counter any significant slowdown in the rest of the world.

The consensus of the nine members of the CAMA Shadow Board for maintaining the cash rate at 2.75% has strengthened in the last month, with members continuing to see more risks to inflation on the upside than the downside.

At the six-month and 12-month horizon, the distributions for preferred interest rate settings remain virtually unchanged: the probability that rates will need to rise in the next six months still equals approximately 30% and that rates will need to fall, approximately 40%.

A year out, the shadow board members attach about 45% probability that the cash rate will need to rise and 37% probability that the cash rate will need to fall.

Paul Bloxham, Chief Economist (Australia and New Zealand), HSBC Bank Australia Ltd:

No comment.

Mark Crosby, Associate Professor, Melbourne Business School:

Great uncertainty about Chinese policy tackling excessive credit growth and asset price growth has been resolved to some extent at the end of June, so a wait and see this month would be appropriate. At the six-month and 12-month horizon, there is still a great deal of uncertainty about the global outlook, and potential for weakness in Europe and the US, in particular. I would expect China’s growth this year and the next to be near the five-year-plan target of 7.5%, and this will underpin reasonable growth in Australia. For this reason, I would see more need to raise rates to more normal levels than to reduce rates over the longer horizons.

Mardi Dungey, Professor, University of Tasmania, CFAP University of Cambridge, CAMA:

No comment.

Saul Eslake, Chief Economist, Bank of America Merrill Lynch Australia:

The RBA seems confident that the 2% decline in interest rates since November 2011 has begun to lift interest‐rate sensitive components of domestic demand (in particular housing) and that the full effects of this are yet to be seen. It also appears to think that the more recent decline in the exchange rate has further to run and will add to the stimulatory impact of interest rate falls, while also (possibly) lessening the scope afforded by the inflation outlook for further cuts in interest rates.

I’m more sceptical than the RBA about the depth and breadth of the recovery in housing, and about the prospects of a recovery in non‐mining business investment. I believe that further reductions in interest rates will be required in order to increase the chances of a smooth transition from growth led by resources investment to growth led by exports and other components of domestic demand.

Bob Gregory, Professor Emeritus, RSE, ANU, Professorial Fellow, Centre for Strategic Economic Studies, Victoria University, Adjunct Professor, School of Economics & Finance, Queensland University of Technology:

No comment.

Warwick McKibbin, Chair in Public Policy in the ANU Centre for Applied Macroeconomic Analysis (CAMA) in the Crawford School of Public Policy at the Australian National University:

Rising volatility in world markets reflects the unsustainability of policies in a number of major economies. The risks are much larger than markets are currently pricing. The opportunity for substantial reform - while central banks covered over global economy cracks with liquidity - has not been taken sufficiently quickly.

The US recovery, due to the energy boom and a quickly recovering US housing market, is likely to attract increasing flows of capital into the US economy. This, together with the inevitable removal of quantitative easing in the US, will put pressure on all countries with large public debts as long-term interest rates rise.

This is an acute problem for Europe and Japan. Australia will need to be ready with appropriate policy responses for the next crisis of confidence in the world economy. The reality is that global interest rates will eventually rise and marginal decisions made at artificially low interest rates will be exposed when liquidity drops.

Fortunately, Australia has been able to sensibly resist the urge for artificially low interest rates but it should be in much better shape structurally. Monetary policy is not the right policy tool for dealing with the significant structural adjustment issues facing Australia. There is a strong argument for not cutting interest rates this month, but this could easily change quickly.

James Morley, Professor, University of New South Wales, CAMA:

Since the last meeting, the Q1 numbers for real GDP have been released and the US Federal Reserve has signalled it is thinking about winding down asset purchases associated with its quantitative easing program, over the next year or so.

The latest real GDP growth rate for Australia is 2.6% on a year‐to‐year basis, which hardly suggests an imminent recession. However, there are some concerns that the weakness in the investment component of output could presage a future slowdown in overall economic activity. Mitigating these concerns are the strength in net exports and the fact that part of the weakness in investment was due to a depletion of inventories, which should lead to stronger growth next quarter, all else equal.

The Fed’s announcement about quantitative easing led to considerable volatility in global financial markets and a further weakening of the Australian dollar. But the underlying story is that the US economy finally appears to be undergoing a more robust recovery than before.

A shift to a more accommodative policy recommendation, compared to last month, reflects increased concerns about weaker growth in China. However, monetary policy in Australia is already quite accommodative and the recent weakness in the dollar should continue even if policy adjusts back towards a more neutral stance, especially given the clearer indication about when unconventional US monetary policies will end.

Jeffrey Sheen, Professor and Head of Department of Economics, Macquarie University, Editor, The Economic Record, CAMA:

National accounts data for Q1 2013 indicate a minor slowing of the economy’s growth to 2.5% for the past year. A major contributor to the decline was public investment. This suggests that future fiscal policy will play a crucial role in future growth. The return of Kevin Rudd to the prime ministership has increased the probability of a Labor victory, though this is unlikely at this stage. However, the probability of a future fiscal consolidation has shrunk, and so monetary policy should not have to play such a big role in stimulating private investment.

Mark Thirlwell, Director, International Economy Program, Lowy Institute for International Policy:

No comment.