JAMES GRUBER. More Rate Cuts Coming

Mar 2, 2020

Get set for further interest rate cuts.

On Tuesday, the Prime Minister, Scott Morrison, ruled out fiscal stimulus to offset the considerable economic impact from the coronavirus. If you think that Mr Morrison is trying to be a prudent economic manager, you’d be half-right. It’s mostly about politics: the Liberals want to appear to be prudent compared with the “profligate Labor Party” and do their best to meet a previous promise of delivering a budget surplus (which won’t happen now). But the announcement effectively leaves the door wide open to more interest rate cuts. And these cuts, like other recent ones, will do more harm than good.

First, let’s look at what the Prime Minister said on the potential economic hit from the virus. Scott Morrison stated that the economy will suffer due to disruption to travel and global supply chains in an interconnected world. The university and tourism sectors wouldn’t be the only ones hurt, he said. Manufacturing and building are being effected as well as imports and exports.

The Prime Minister said he could no longer promise a budget surplus for this year but he urged people to spend locally to help prop up the economy. Stimulus, though, was ruled out:

“We’re not a government that engages extreme fiscal responses,” he said.

“If we can overcome the virus, we can overcome the longer term and medium term impacts.”

And he said it was a good thing that the budget was in decent shape.

“Hands up those who thought there was going to be a coronavirus epidemic when the budget was released last May,” he said.

“Of course no-one did. These are unknown global shocks. So we’re dealing with those shocks and we’re processing that through how we look at the budget as we go into May and beyond.”

If the government won’t stimulate the stuttering economy, that leaves the Reserve Bank of Australia (RBA) and monetary policy. Economists will start calling for rate cuts, probably over the next week – they are almost algorithmically tuned to call for government stimulus whenever the stock market has a dip, the housing market corrects or a black swan event such as coronavirus occurs. With the economists, the media will jump on board with dire economic impact stories and lobby groups will pile on with unison calls for the government to do something; anything, in fact. Then the RBA will “forced” to cut.

Of course, the RBA has known little but cutting rates over the past three decades. Astonishingly, Australia’s cash rate was 3% at the depths of the financial crisis in 2008-2009. It’s now at 0.75% and heading lower. Real rates (cash rates – inflation) have been largely negative since 2014. And that’s using Consumer Price Index (CPI) figures which seriously underestimate real inflation, as I explained in this article.

Using credit growth as an approximate substitute for CPI would put real rates in deeply negative territory for all of this century. This “unconventional” (read: debauched) monetary policy has led to serious problems, including:

1) Low interest rates penalise savers. They especially hurt those who rely on their savings, such as retirees. Many of them aren’t happy about it, as I’ve outlined previously:

“It seems older Australians are beginning to link the RBA to low deposit rates and that may not bode well for [RBA Governor] Mr [Philip] Lowe.”

2) Negative real rates naturally lead to speculation on all kinds of assets. Stocks, bonds, commercial property, houses, cars, art, dogs – you name it, everything has been bid up. A lot of assets are now extremely overvalued, unless current low interest rates and bond yields are here to stay.

3) Asset price inflation leads to greater inequality. The wealthy own assets while the poor don’t.

4) Low rates keep many over-indebted businesses alive when they should be dead. This undermines economic productivity. For instance, these so-called zombie firms can get loans that should instead be going to profitable businesses which can put them to better use. In 2018, The Bank For International Settlements estimated that 1 in 10 U.S. companies were zombie firms. I imagine the figure in Australia isn’t dissimilar.

5) Cheap money allows private equity (PE) and venture capital (VC) to prop up many companies which shouldn’t exist. With PE or VC backing, some businesses can price products below where they should be to try to grab market share, but without any real hope of ever making a profit. WeWork, anyone? (although there are numerous other candidates)

6) Tonnes of debt. It’s funny how debt was a key subject in business circles post the financial crisis, but now barely receives a mention. Australia’s household debt at close to 200% of disposable income is enormous. And the banks’ significant exposure to residential property is of particular concern.

7) More debt means greater “financialisation” of the economy. That is, resources flow into the finance sector, making it more important vis-a-vis the rest of the economy. Want to know why financial companies are still doing well and their employees can get ludicrous salaries and bonuses? -that’s financialisation of the economy.

8) Low rates hurt a number of sectors, insurance being among the more visible. Near-zero rates reduces investment returns that insurers hold against their future claims liabilities.

While economists and the RBA will talk up the benefits of further cutting rates to spur the economy, they will also know that any such cuts will provide only a short-term fillip at best. Meanwhile, the problems mentioned above will become ever more stark.

You may ask, what’s the solution then? Well, low interest rates have distorted our economy to such a degree that there is no easy path ahead. If history is any guide, governments always choose to inflate their way out of debt problems. For that to happen, interest rates have to remain below inflation for a sustained period. That could mean interest rates at zero, or negative, very soon and the RBA trying to keep them there for a long time to come.

James Gruber is a businessman and writer. He authors a blog on Australian business issues: Money, Mobs & Moguls.


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