Lowering The Cash Rate Is No Panacea

Last week the Reserve Bank of Australia lowered its cash rate to a record low.The Australian dollar tumbled, and there are rumours that George Soros bet US$1 billion against the Aussie in expectation of that. But just because the central bank lowered the cash rate does not mean that Australia will have softening demand from China offset by a domestic recovery.

At the onset of the global financial crisis, the Federal Reserve quickly slashed the fed funds rate and injected enormous amounts of liquidity into the financial system. Even the RBNZ received a few billion dollars in Fed largesse. Not long after, the Bank of England joined the party of quantitative easing. The UK even nationalised most of its banking sector.

Fast forward to today. The European Central bank has been doing its own form of quantitative easing and sovereign debt restructuring since 2010. While there is enormous liquidity in the financial system, private sector demand for credit is nowhere near pre-crisis levels. The Bank of Japan is doubling down on quantitative easing in the vain hope that higher inflation will somehow kickstart the Japanese economy.

If everyone is engaging in quantitative easing, the country that does not will quickly find its exports uncompetitive. The New Zealand dollar is currently at record highs – not because New Zealand is an economic miracle but because there is a global reach for yield. It just so happens that our interest rates – and dividend yields – are very attractive in a low interest rate environment.

This is because although quantitative easing has succeeded in keeping interest rates low, it has not flowed through into substantial investment and consumption spending. The United States recently surpassed the “socialist” Eurozone for youth unemployment and underemployment. Household incomes have stagnated since the 1970’s. Corporations are running massive surpluses and can even issue long-term debt to finance dividends to shareholders because that is cheaper than repatriating capital from offshore.

The tragedy of the Australian story is that they have squandered the boom. I shared with you a while back a McKinsey Global Institute report that clearly shows how their economy has had poor productivity growth, pursued resource projects barely economic even at sky high commodity prices and failed to ensure that the whole Australian balance sheet was ready for any inevitable downturn.

My opinion is that the Reserve Bank of Australia will keep cutting interest rates. There will be a change of government and the incoming Liberal government under Tony Abbott will not be able to implement any significant supply side reforms because they will be in a massive slump.

Lowering the cash rate is no panacea for an economy already plagued by malinvestment. Because Australia has a larger balance sheet than New Zealand, it will be interesting to see if they eventually copy the Federal Reserve and join in the quantitative easing party. Australia sure is important for us to watch – our economy depends more on theirs than many in New Zealand want to admit.