Here’s a question to start your day. Do you know what ‘orthogonal’ means? I had no idea the word existed until this morning. But thanks to Reserve Bank of Australia governor Glenn Stevens, I’m now fully enlightened.
In an interview with the Financial Review yesterday, Stevens responded to a question about the transition underway in the Australian economy, away from mining to whatever else can fill that gap…
‘Well, I think the transition is clearly still under way and I think we’re going to be talking about this handover transition issue for a while yet. That was largely inevitable, I think, given the size of the episode that we have been in, with the mining story and so on. And I also think that is given some of the other changes that have been going on in the economy, more or less independently of the mining boom. If you think about the changed behaviour of consumers, the rise in leverage they had in the preceding decade, they’re handling that fine. But that’s a one-time adjustment; it’s not going to happen again. So the notion that the consumer would be the driver of growth in the way they were in some of those earlier periods, that isn’t going to happen; we have been saying that for some time. So, and that is orthogonal, more or less, to the mining story. So that’s a transition too.’
Err, OK then. ‘Orthogonal’ means ‘intersecting or lying at right angles’, at least according to one definition. So he’s saying there won’t be a smooth handover from the mining boom to consumer spending, housing investment, or whatever other growth options are out there.
That’s hardly new news though, is it? The market has known that for a while. It’s why the ASX 200 is well off its recent highs even though US markets continue to power higher.
What’s interesting is that the market, and resources in particular, remain under pressure despite the recent sharp fall in the Australian dollar. A falling currency should provide stimulus to an economy, in the sense that it is inflationary.
That will eventually happen, but it’s worth looking at why the market is not currently ‘celebrating’ a much lower Aussie dollar. First, check out the performance of the Aussie versus the greenback over the past year.
It finished 2013 around US$0.90, rallied to 95c by mid-year, before nose-diving to just over 82c now. In the interview, Stevens nominated 75c as an area where it might stabilise.
The thing is, much of the weakness in the Aussie dollar is really a story of US dollar strength, rather than broad-based weakness against a range of trading partners. As the AFR points out, on a trade-weighted basis, the Aussie isn’t much lower than where it was a year ago.
So if you’re just looking at the Aussie/US dollar exchange rate, the weakness in our currency is a little overblown.
The takeaway is; currency weakness will eventually provide some stimulus to economic activity, but it will take longer to flow through and may be more muted than in the past.
One other reason for this is that the Aussie dollar hasn’t been this low (versus the US dollar on a sustainable basis) since early 2007. In other words, for the past seven years or so, the structure of the economy has adjusted towards dealing with an historically high exchange rate.
A strong dollar makes imports cheaper, keeping inflation low and encouraging consumption of imported goods. With the dollar falling, and assuming the falls are sustainable, prices of imported goods will increase. If companies pass the increases on, it will impact demand…if they absorb the rise, it will impact profit margins.
There will be a hit to the economy from somewhere…and it’s not yet certain that the benefits of a lower exchange rate will offset the disadvantages.
Which means interest rate cuts are again in investors’ sights. On this front though, the comments from Stevens could disappoint. He’s in no hurry to cut interest rates again. Sensibly, he knows, with interest rates already at generational lows, that he’s in unchartered territory. He’s concerned that cutting interest rates further might impact on sentiment more than they boost it.
He also acknowledges that the impact of cutting rates again is uncertain. He also acknowledges, for the first time, the impact on savers from such low rates. Although having said that, when push comes to shove…he’ll shove savers out the door to rescue the debtors. Here’s the relevant question and answer:
‘AFR: When you get to this level on a cash rate, can cutting below that actually deliver much more stimulus to the economy?
‘MR STEVENS: Interesting question. I wouldn’t want to say that, at this level, we’ve run out of effective capability to deliver stimulus. So I wouldn’t say that. I think what you would say is that these are the sorts of levels where things that could accompany even lower rates that are a little bit unhelpful enters the thinking. So there’s more of a cost-benefit calculation to be done, I suppose. Perhaps that’s better said as more of a risk-reward calculation. I’m not saying that it’s definitely negative. But there is more thought to be given, I think, to those things. Savers, you know, their incomes have fallen a lot. And most of my correspondence now is from them. And you would still expect, I think, that lower interest rates are stimulatory for the economy. But we’re certainly reaching levels where, for those who have interest rates as their income, the income effect on them is clearly quite something to be thought about.’
In other words, he’s hesitant to cut interest rates if it’s because the economy is in trouble…as that would impact confidence. And according to Stevens, it’s all about confidence. He reckons the policy settings are in place to achieve strong growth…all that is missing are ‘animal spirits’.
I would argue that people aren’t dumb. That their animal spirits are somewhat subdued because record consumer debt levels and already near record low interest rates mean demand won’t take off anytime soon.
So why invest heavily in such an environment? That is the trap of record debt levels and record low interest rates. Australia is on its way to falling into it.
The political situation is not helping things either. In his opaque, hedged and bureaucratic way, Stevens gave a serve to politicians for playing politics (what else does he expect) over the budget. While not an immediate crisis, Stevens says on a five-year horizon Australia risks losing its AAA credit status if we don’t take action on budget sustainability.
That would damage our credibility in the eyes of foreign creditors. Given our reliance on foreign capital, this would be a huge blow to the economy. Here’s how Stevens put it:
‘But what we do need to do, and this is a repeat of earlier sermons on my part, the real issue is that five-year-plus horizon where as a community we have voted for good things to be given to us by the government, or done for us, and we have not voted for the revenue that pays for it. And I guess I would say that I think much of the public debate about the fiscal position still is carried on as though that reality isn’t actually real. But it is real, as best we can tell on the best estimates that Treasury and Finance can do. That is a real issue. The conversation we need to have is about heading that problem off before we hit it so that we don’t ever get into the position of losing credibility in capital markets and then be forced to be much more pro-cyclical with our policies.
‘I don’t want to get into a detailed discussion of budget measures and so on, but I think the past year shows that this is not an easy conversation to have. It’s very difficult, and it will require strong political leadership I think, not just from the government, but from other political parties and individuals who claim to be serious. You have to have a serious conversation about this stuff and not get into slogans and name-calling and that stuff. The serious issue is that five-year horizon.’
The good news in all this is that we have a central bank governor who understands the myriad risks that face the economy in a post-China boom environment. Unfortunately, he’s too much of a bureaucrat to really say what he thinks. The RBA is an independent body; he should be able to say what he believes (for the good of the country) with impunity.
Instead he talks too softy on major issues that aren’t directly related to his beat…setting the price of credit. But in today’s landscape, everything impacts monetary policy deliberations. Stevens should just tell it like it is.
For Markets and Money