Inflation, negative growth, interest rates and currency – economy struggles to avoid global implications

Post GFC economic scrambling has finally reached Australia’s shores, prompted by the release of negative inflation data for the March Quarter of 2016. The seasonally adjusted -0.1% inflation was the first negative quarter since March 2009. The not entirely unexpected news pushed the Australian Dollar down immediately, before capital markets recovered their equilibrium. It was not long, however, before the RBA weighed in, delivering record low interest rates, pushing the Australian Dollar back down below USD0.75.

These factors, which hit budget week and saw the RBA’s rate cut come on the day the Federal Budget was released, are the standard response of central bankers the world over. The expectation is this rate cut, plus perhaps another, will lead inflation back up by providing modest stimulus to the economy and adding to economic growth. 

As Adam Boyton, Deutsche Bank Australia’s Chief Economist wrote in the Australian Financial Review in May. “Interest rate cuts typically increase demand across the economy. … As a result GDP growth is a little stronger than it otherwise would have been as is employment growth – although with a lag.”

Capital markets have already or are close to locking in another interest rate in their forecasts. They are doing this in the near certain expectation that the US Federal Reserve will struggle to increase its own interest rates, placing upwards pressure on the Australian Dollar and necessitating, according to the orthodoxy, further domestic interest rate cuts.

However, the recent international trend has been counter-intuitive, if not unorthodox, at least in this macro economic sense. Globally, low inflation rates, coupled with lower interest rates have seen lower wages growth (negative in some economies) and no improvement in economic growth.

The signals are that the international experience is fast approaching Australia’s shores, if it has not arrived already.

As Mr Boyton points out, “…the unemployment rate has been falling for almost a year now without any increase in wages growth. That suggests that too-weak wages growth might not be solved by adding a little more demand into the economy.”

The dilemma that arises is that the ‘fuel’ from lower interest rates ends up flowing into less stimulatory areas of the economy, than the consumption increases that are typically driven by an expansion in wages. While that can lead to even deeper interest rate cuts, the trajectory of less stimulatory outcomes might well continue.

That description goes some way to explaining why Australia’s house prices continue to boom. Mr Boyton puts it succinctly, saying “…locally, a key risk would seem to be that instead of generating consumer price inflation we end up generating house price inflation instead.”

Despite that risk, the expectations of still lower interest rates seem well-founded. There seem few alternatives after all, even if the response from the economy delivers a less effective outcome than was once the case.

As Don Brash, the former governor of the Reserve Bank of New Zealand commented, “You’ve only got one instrument. You can only really hit one target effectively. … Logically, it should be some rate of inflation. … Is it sufficient? Probably not.”

Dr Brash’s comments are all the more significant because as head of RBNZ he introduced the world to inflation targeting, using interest rates as the primary lever to meet the targets.

As the pundits commented at the World Economic Forum event in Davos recently, the world should expect lower growth for longer. That is uncharted territory for central bankers, including the RBA. It may not be the end of the era of monetary policy primacy, but their options appear quite limited, at least compared with the past.