Why the RBA Won’t Raise Interest Rates

The Reserve Bank of Australia meets today to decide on interest rates, and some commentators are calling for an immediate rate cut, reasoning that the next chance to do something will not be until February next year (the RBA doesn’t meet in January).

What — do they think the RBA is the Fed or something? That is, as soon as the market crashes by a few percent, it’s time to open up the liquidity spigots and reassure the speculators?

Thankfully, the RBA aren’t that stupid. At least I don’t think they are. We’ll know by 2pm this afternoon, but I’m tipping they keep rates on hold.

There is one strong hint though that the next move in interest rates will be down, not up. The afr.com explains why:

Bets are mounting that weakness in both Australia and the global economy could force the Reserve Bank of Australia to cut rates within 12 months, despite an almost-consensus view among bank-based economists that the RBA’s next move is up.

Hang on…Australia is in the middle of one of its greatest terms of trade crashes ever and nearly every single bank economist thinks rates will be higher next year? What are they teaching these people at uni, seriously?

Here’s a tip, people. It is very unlikely that the RBA would ever raise rates into a crashing terms of trade. It just wouldn’t make sense. You don’t need an economics degree to know that…only a modicum of common sense.

A falling terms of trade reduces national income. This means that, at an aggregate level, disposable incomes are falling.

Do they really think the RBA is going to add to that reduction in disposable incomes by raising rates? Of course not. Why did rates fall by so much from 2011 to 2013? It was because of the first leg down in the terms of trade.

The nasty side-effect of this interest rate cutting cycle was a booming housing market…mostly centred around Sydney and Melbourne. On the plus side, it did increase dwelling approvals to a cyclical high (meaning more supply will come into the market in the years ahead), but the house price speculation that came with it could prove destabilising for the economy if it continues to get out of hand.

Another round of interest rate cuts could well do that. So my guess is that the RBA won’t move on interest rates until there is some movement on the ‘macroprudential’ front. This refers to changes to rules or regulations that could curb investor speculation, or make banks hold more capital against certain types of loans.

And don’t forget the Murray Report is currently in the hands of the government. This is likely to recommend changes to the financial system that will at least stem the flow of credit to the housing sector.

Speaking of house prices, you’re seeing increasing signs that price gains are beginning to cool. Yesterday, RP Data reported that for the month of November average capital city prices fell 0.3%. On a year-on-year basis, they’re still up 8.5%, but the rate of growth is slowing.

More importantly, the returns are nearly all coming from Sydney (up 13.2% yoy) and Melbourne (up 8.3% yoy). Bad luck for the rest of Australia. I’m not sure how that wealth effect theory is going to play out.

Which is a bit of a worry for the RBA. The whole rate cutting rationale was to create a housing boom (as in construction and consumption) to offset the faltering mining boom. As we head into 2015, that doesn’t look like it’ll happen. Construction activity looks to have peaked, and consumers aren’t exactly champing at the bit, are they?

That’s what happens when you base an economy around a flawed investment idea (China will soak up our commodities at high prices forever) and leverage that short term income gain on property speculation.

It leaves you desperate for lower and lower interest rates when growth slows — because in a structurally weak economy, there’s no real other answer. The government could get serious about reform, but that’s too hard. Better to kick the can down the road and hope ‘something will turn up’.

Tony Abbot did just that yesterday by saying that iron ore prices would pick up soon. It’s all very Micawberish.

Ironically, something did turn up for Dickens’s famous character…he emigrated to Australia and got a respectable job!

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Greg Canavan is a Contributing Editor at Markets & Money and Head of Research at Port Phillip Publishing. He advocates a counter-intuitive investment philosophy based on the old adage that ‘ignorance is bliss’. Greg says that investing in the ‘Information Age’ means you now have all the information you need. But is it really useful? Much of it is noise, and serves to confuse rather than inform investors. And, through the process of confirmation bias, you tend to sift the information that you agree with. As a result, you reinforce your biases. This gives you the impression that you know what is going on. But really, you don’t know. No one does. The world is far too complex to understand. When you accept this, your newfound ignorance becomes a formidable investment weapon. That’s because you’re not a slave to your emotions and biases. Greg puts this philosophy into action as the Editor of Crisis & Opportunity. He sees opportunities in crises. To find the opportunities, he uses a process called the ‘Fusion Method’, which combines charting analysis with more conventional valuation analysis. Charting is important because it contains no opinions or emotions. Combine that with traditional stock analysis, and you have a robust stock selection strategy. With Greg’s help, you can implement a long-term wealth-building strategy into your financial planning, be better prepared for the financial challenges ahead, and stop making the same mistakes that most private investors do every time they buy a stock. To find out more about Greg’s investing style and his financial worldview, take out a free subscription to Markets & Money here. And to discover more about Greg’s ‘ignorance is bliss’ investment strategy and the Fusion Method of investing, take out a 30-day trial to his value investing service Crisis & Opportunity here. Official websites and financial e-letters Greg writes for:

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