The RBA has managed to dodge a bullet on interest rates, but dark economic clouds are looming

by Admin
August 5, 2024

That’s the thing with silver linings. They’re usually attached to dark clouds.

After salivating for months about the prospect of interest rate cuts and blithely ignoring reality, financial markets suddenly are in a mad panic about the fundamentals driving the push for cuts.

This time last week, our stock market surged to a new record, buoyed by the idea that we may exit the inflation danger zone without the usual after-effects; the self-induced slowdown that leads to recession.

But no sooner had the champagne corks hit the ceiling, Wall Street encountered a dose of the jitters which has since turned into a full-scale rout as investors make a mad rush for the exits.

The fear of a global slowdown has quickly permeated global markets. And even though Australian stocks have lagged the incredible boom on Wall Street, the strong gains since last November have pushed local companies well beyond their long-term value measures.

Why? Because investors were lulled into a false sense of security that as interest rates eased, markets would remain buoyant and few, if any, believed the economy would slow enough to tip into recession.

It’s possible that may still come to pass. But the violent shake-out on Wall Street and across the globe in the past few sessions finally has knocked some sense into investors.

Even with the carnage of the past few days, our market is only off 1.5 per cent since the start of the financial year, while some US indices are still in the black, giving an indication of just how fast stock markets have been running in recent weeks.

Not everyone has been so lucky. Japan, in contrast, has shed 20 per cent since July 1.

The reaction across the developed world in the past week will no doubt be a sobering influence on today’s Reserve Bank of Australia board meeting.

Pushing the idea of another rate hike as stocks are in meltdown and money markets are pricing in multiple rate cuts would be a bold step.

Not that it ever was on the agenda. After the benign jobs figures a fortnight ago and the slightly better than anticipated inflation data last week, the chorus of calls for even more punishing rate hikes has abated.

The chorus of calls for another rate hike have been silenced, much to the relief of households.(AAP: Bianca de Marchi)

Talk about timing

Imagine a scenario where last week’s inflation numbers were a smidge higher than those delivered.

Having threatened to raise interest rates all year, all while parroting the global central bank mantra that “we are data dependent”, the RBA could well have been forced to jack up rates just to maintain its credibility.

And had Wall Street, which has been lurching wildly for weeks, performed its high-wire nosedive this Thursday instead of last week, we’d have found ourselves wildly out of step and in a world of pain.

Stock market gyrations normally aren’t of great concern to central banks. And there’s a decent argument that Wall Street’s technology giants have needed a retreat from their nosebleed levels.

But there is more to this shake-out than a mere market correction.

The underlying basis for the tumultuous reckoning was America’s unemployment numbers, which ticked up to 4.3 per cent from 4.1 per cent previously, coming off the back of a raft of weak economic indicators.

That prompted a great deal of finger-pointing at US Federal Reserve boss Jerome Powell who last week held off from a rate cut, a move that now seems to have been remiss.

As the graphs below illustrate, Canada, the Eurozone, the UK, Switzerland and Sweden already have begun cutting, some of them twice, in response to weakening economic growth.

Who’s in charge here?

As individuals, we often tend to oscillate between euphoria and despair. When it comes to economics, that behaviour manifests itself in booms and busts.

After centuries of missteps, governments and, these days, central banks try to smooth out the cycles by slowing activity in booms and speeding it up during busts.

It’s no easy task, largely because there is often a long delay between their actions and when they finally start to take effect.

We’ve just emerged from a boom caused by over-stimulating during the pandemic bust, which was made worse by soaring energy prices after Russia’s invasion of Ukraine.

After three decades of ever-slowing inflation, the world’s biggest central banks, including America’s and the RBA, refused to believe the sudden shift to soaring prices was anything but a temporary affair.

Eventually, they were goaded into action by money markets that abandoned any guidance from the US Federal Reserve. Embarrassingly, it was forced to follow the markets rather than guide them to the future.

As a result, it was late to the party when it came to rate hikes. Now, it seems, it could well mishandle the rate-cutting cycle.

America’s official cash rate remains anchored at 5.25 per cent. But five-year Treasury notes on the money market yield just 3.5 per cent after sudden price shifts in the past few days.

It’s a similar story here. Our official cash rate sits at 4.35 per cent while five-year government bonds yield just 3.4 per cent.

Once again, it appears to be money markets dictating economic policy.

Over the past two days of trading, $100 billion has been wiped off Australian shares.(AAP: Steven Saphore)

How economists got it wrong

Until just a few weeks ago, there was a considerable body of economists calling for more rate hikes.

They’ve suddenly dwindled in number but many believe the data we have seen to date demonstrates a clear need for further hikes. Inflation, they argue, is still too high.

To an extent they are correct. But there are three things they seem more than happy to overlook.

The first is their obsession with “data dependence”. The problem with the data upon which they rely is that it delivers a good picture of the immediate past, not the future. Obviously that’s a given, but it remains a valid criticism.

The second is that while they readily agree that further rate hikes will have little effect on curbing the services inflation driving our pricing structures, they argue for them anyway, primarily because they are “data dependent” and interest rates are all they have.

And the third is that we couldn’t possibly be in economic danger because we still have an unemployment rate that is close to record lows for the modern era.

Almost everyone expected labour markets to cool and unemployment to rise when the RBA first started hiking two years ago. It has, but at a much slower pace than anticipated.

But a look back at history may offer an explanation.

This graph of the US jobs market demonstrates that unemployment doesn’t gradually rise during a rate-hiking cycle. Instead, it jumps dramatically when the economy tips into recession, a time when rates normally would be cut.

The trend of unemployment in the US shows it only rises when the economy begins to tank.(Supplied: US Federal Reserve Cleveland)

The grey bars are recessions while the blue line is the unemployment rate. In every recession dating back to the 1950s, jobless numbers swell dramatically only when the economy starts to tank.

Part of the reason could be that employers want to hang on to workers when times are fair to good and only are willing to jettison them when they’re convinced things really are about to turn ugly.

The lesson from the past is that when unemployment starts to rise, it does so at startling speed. The steady lift many were expecting was never going to occur.

It is clear that our economic growth has stalled, household spending has plunged and, more concerningly, the generational divide has become far more pronounced, concentrating the pain on a younger cohort of Australians.