The RBA’s policy toolkit is threadbare, it may soon resume currency jawboning
The RBA may have an enviable 2.00% of rate cuts it can deliver, but it also has bubble in its housing market and cutting rates now may derive little benefit and generate a bigger problem down the road. Its rate cutting tool is blunt and rusty and may infect the patient. It has been increasingly reluctant to use it, preferring instead to attempt positive persuasion, talking up the economy and down-playing the risks. However, the recent media circus over excessive property prices and investment, and the politics of housing policy has both highlighted the inadequacy of further rate cuts and threatens to undermine economic confidence. With cracks starting to appear in the economic façade and global growth confidence faltering, the RBA may soon resume its next best policy of talking down the exchange rate.
The RBA’s toolkit is threadbare
The RBA is looking into its policy toolkit and doesn’t like what it sees. There isn’t a lot left, and what is left they don’t want to use for fear of causing more problems than they solve.
This problem is not unique to the RBA; the BoJ reluctantly cut rates to negative territory after pinning their hopes on full-throttle quantitative easing. The ECB cut further into negative rates in December, under some duress, and looks set to go further. But both central banks are finding these policies have raised other problems, undermining the profitability of their banking system and confidence in their economies.
The RBA still has 2.00% of rates to cut, and some central banks may look on with envy at this traditional power to cut rates. However, those central banks don’t have a bubble in their housing market and over-levered household sector.
The RBA have been reluctant to cut rates since 2014, and led the call for prudential measures to restrain investor lending and excessive house price gains in the major cities from around Q3-2014.
The development and implementation of these prudential policies was painfully slow and started to have effect from around mid-2015. They were wrapped up in broader initiatives resulting from a Financial Systems Inquiry that also recognized the risks to Australia’s financial system from excessive mortgage lending and required banks to raise their average capital risk-weight on mortgages.
Under the cover of these measures to lean against mortgage lending, the RBA cut rates by 50bp in the first half of 2015, essentially keeping the housing market in rude health; including spurring investment lending for property to new cyclical peaks at around 11%y/y, even as banks were supposed to be tightening standards.
The housing lemon has been squeezed
Whether it can be described as rational or not is debatable, but in few places in the world is there such a heavy bias to invest in property than in Australia. This is promoted by government taxation policy, aided and abetted by banks and the wealth management industry. In the most recent extension of the property peak it would surprise many around the world to know that retirement savings funds played a role, allowed to borrow to invest in property investment using non-recourse loans.
The RBA were prepared to boost the housing market via rate cuts early in the mining investment down-cycle (from late 2012) with some fervor, anticipating that it would boost prices somewhat (from arguably already high levels), aiming successfully to spur new building activity and related consumption and services. This has been a successful part of the plan to cushion the economy. But it appears now that they think the juice has been squeezed out of this lemon.
RBA Governor has dutifully warned many times that there has already been a once in a generational expansion on household borrowing and leverage (from around the mid-1990s) and households capacity to grow their borrowing further is largely spent. It is patently evident that most of this borrowing has gone into pumping up housing prices. Australia’s capacity to borrow more is low and its house price stock value in relatively high. Further lowering interest rates potentially pumping up house prices even further may help spur growth a bit more, but it will also boost financial instability risks. As such for small gains now, the risk is high of much bigger and more prolonged losses down the road. As such, more than ever before, the RBA may be willing to see sluggish growth in the near term before using its remaining interest rate ammunition.
A policy of cheer-leading
Instead of simply cutting rates to ensure the economy is running stronger, the RBA appears to have used positive psychology to attempt to boost animal spirits, repeatedly pointing out the positives (tourism spending up, employment growth above trend, business credit up, conditions ripe for a rebound in investment, China and trading partner growth stable, exchange rate adjusting).
The RBA didn’t rush to offset the roughly 20bp of effective policy tightening enacted by big banks raising their mortgage rates in October last year in response to the regulators implementation of macroprudential tightening. Instead the RBA Governor Stevens told the domestic market to chill and wait to see how events unfold.
In its first round of meetings and reports this year in February, the RBA continued to emphasize the positive and down-play turbulence from abroad.
This hold the line approach to policy was applied to its rhetoric on the exchange rate. In his parliamentary Testimony on the 12 Feb. RBA Stevens said that, “There was a period when we felt that the exchange rate was not quite doing the job we might have expected, and we said so. It then adjusted, and our language has of late been, ‘It’s adjusting.’ I would still say that.”
But in a sign in that there may a looming return to a more dovish stance on the exchange rate, he added with just a hint of his trade-mark wry grin that, “I would also note that commodity prices are continuing to fall as we speak.”
Cracks in the façade
There are cracks in the façade developing now, and it is getting harder for the RBA to hold the line and talk up the economy. It may feel forced to rummage around in the depleted tool box for something that might bolster the recovery before too long. The global outlook has deteriorated further, the most recent surveys of business confidence have stalled, unemployment rose back to 6%, wage growth fell to a new record low, and the capital expenditure survey again disappointed with weakness persisting in all sectors, including the non-mining sectors.
But the rate cutting tool has a dull rusty edge, it might do more harm than good, especially if employed alone.
Curtain pulled back on a housing bubble
A proposal by the opposition party to limit negative gearing and raise the capital gains tax on investment property has pulled the curtain back on Australia’s biggest underlying problem, its excessive household debt and dangerously high house prices. The virtual ink spilled on this issue and frenzied political debate has dominated the media, resulting in intense talk of an early election (potentially July) and the government bringing forward its own tax proposals to April ahead of the May budget.
With the curtain drawn on the housing market vulnerability the risk is that it starts to falter and drag down overall economic confidence. Add into the mix, the political debate that will continue to highlight this vulnerability, induce broader uncertainty, and potentially feature into speculation over when the RBA might best use its blunt rusty rate cutting tool, and economic confidence may face further headwinds. Needless to say the global outlook is not helping either.
It’s fascinating to read the rebuttals on the housing market vulnerability in recent days. Of course there are mitigating factors that suggest the housing market is not a bubble; otherwise 180% household debt to income would be a calamity.
The AFR reported that banks retorted, “While accepting that 40 per cent of new mortgages are interest-only, bankers say these are not “low doc” loans to borrowers unable to repay principal. Rather, the high level of interest-only loans reflects the large numbers of borrowers taking advantage of negative gearing, where interest payments are tax deductable.”
This essentially admits that Australians have invested heavily in property in a highly geared manner to take advantage of tax breaks. This is hardly a strength of the underlying market. These investors may have been deemed creditworthy by the banks, but this does not change the fact that they may feel a significant chill and attempt to sell into a falling market.
What should the Australian public make of the warnings by PM Turnbull that the opposition party’s proposal to reduce investment property concessions will cause house prices to fall sharply? He said, “Australians know that if you take away a third of the crowd at an auction the price you get for your house will be lower.”
This gob smacking statement screams run for hills on many levels. One is that even the PM thinks it’s normal that property sales are a spectator sport at emotion charged auctions. A big crowd makes for a big price. The fever-pitched campaign that goes into promoting these auctions is obscene and yet run of the mill. Second, The PM, like most Australians, displays little thought for what might be a sustainable fair value for housing, only about what might motivate the current group of buyers, be that in a system that distorts their behavior or not. Thirdly, if the current tax system is set up so that altering it in a manner that may level the playing field will remove a third of the buyers in the market then there is indeed a problem.
Whether the government reduces investment property tax concessions or not, it might make investors think twice about buying that sixth property. And while the government is railing on about the damage and havoc that the opposition party proposals may make, the pundits still predict that the government itself will roll-back negative gearing concessions to some extent in its upcoming tax policy.
Policy makers don’t want to scare the natives
Policymakers appear to know very well that financial instability risks are elevated in Australia, which is exactly why they enacted prudential policy measures last year to address it. At the same time they do not want to scare the natives, which is why they also often argue that property prices are not over-valued and the quality of lending and strength in the banking system is solid. They have claimed that these prudential policies have successfully mitigated the risks and all is well.
But elevated they are, which is why the RBA is reluctant to cut rates further and has adopted a policy of talking up the positives in the hope that recovery will build on its own fledgling confidence. Plan B of further easing policy is much more unpalatable than it was before the most recent surge in house prices and debt.
Jawboning the exchange rate lower is the next best option
Nevertheless, the RBA has attempted to reassure the market that it has the scope to cut interest rate further if it decides this is necessary. However, we should expect the RBA to resume jawboning the exchange rate lower before it cuts rates further.
The rate cutting tool is blunt and rusty and might leave the patient infected, better to try and engineer a weaker exchange rate. The RBA could hold its nerve this week and stay with the policy of positive persuasion, chill-out and watch and wait for the recovery to build momentum. But the risk is that it includes some comment arguing a lower exchange rate would be useful.