Reserve Bank needs to solve increasingly complex economic growth puzzle

RBA governor Philip Lowe

The Reserve Bank of Australia has a mystery to solve about the economy, and its solution will be a factor if there’s another interest rate cut.

Another cut has looked improbable for sometime given the turbocharged housing markets of Sydney and Melbourne and better economic growth. But the bank is wrestling with the puzzle of where growth is going to come from. The housing investment boom is starting to exhaust itself — while still strong, it will be detracting from growth later this year — after supporting the economy’s transition from the resources investment boom. But what, in turn, will replace it? As we’ve previously noted, non-mining investment is proving to be elusive as a replacement; in the RBA’s words, “it is difficult to know if and when a stronger and durable recovery in non-mining business investment might take hold”.

That leaves consumer or household demand as the next best source of growth until non-mining investment picks up. Except, therein lies a problem, before you even get to low wages growth: the high level of household debt. As RBA governor Philip Lowe pointed out in a speech in Brisbane a fortnight ago:

“The higher debt levels also appear to have affected how higher housing prices influence household spending. For some years, households used the increasing equity in their homes to finance extra spending. Today, the reaction seems different. This is evident in the estimates of housing equity injection. In earlier periods of rising housing prices, the household sector was withdrawing equity from their housing to finance spending. Today, households are much less inclined to do this.”

With wages growth remaining at record lows and the under/unemployment rate not expected to fall markedly, that means household demand lacks the fuel to drive growth. 

Unemployment fell in seasonally adjusted terms in April to 5.7%, according to figures released this morning, but the Australian Bureau of Statistics’ preferred trend figure remained steady at 5.8%. In trend terms, employment grew by around 20,000 in the month — the bulk of it, pleasingly, full-time jobs. But as the ABS notes, trend growth over the last year has been below the long-term trend of the last two decades. There was also a small fall, in both trend and seasonally adjusted terms, in hours worked. None of this is strong enough to signal that workers will be in a position to push for wage rises any time soon.

What about our terms of trade, which have been improving recently? A lot of that extra income isn’t staying in Australia, but passing through to the foreign owners of the LNG, iron ore, coal and other projects now benefiting from the upturn — and our flawed tax and royalty systems aren’t doing a great job of keeping that wealth here.

This problem isn’t supposed to have happened — non-mining investment was supposed to pick up, and an upturn in wages was supposed to have finally shown up. That clearly isn’t happening and the RBA is doubtful that it will occur in time to offset the fall in housing investment.

Hence the bank, as it indicated in its board minutes for its May meeting, has started closely monitoring the labour and housing markets. In the back of its collective mind will be a possible rate cut, which will need to be made well ahead of the expected slide in housing investment starting to detract from economic growth. But the bank wants to reassure itself that any rate cut to help boost consumer demand (and take pressure of indebted households) will not set off another surge in the Sydney and Melbourne housing markets, and in the still troubling (for the RBA) apartment sector.

And the bank is all too aware that with the cash rate at 1.50%, it doesn’t have much firepower left to support a sharp drop in demand, and nor do consumers. That is why it has been asking the federal government for the past 18 months to step up spending on infrastructure — which Canberra has ignored (what extra infrastructure spending there was in the budget won’t make an impact for years).