What does it all mean?

The Reserve Bank Governor may be regarded as an optimist, but he is better regarded as a realist. His reading of latest economic evidence suggests that the Australian economy is in good shape, and he is keen that all Australians are made aware of the facts. The last few talks by the Reserve Bank Governor have been on the theme that Australians have become too gloomy:

“our domestic tendency towards the ‘glass half empty’ view”.

This is another talk on the same theme.

Pessimists have raised various issues from time to time. The Reserve Bank Governor has attempted to deal with these one by one, using facts rather than fallacies or fears to address the issues. Issues include the outlook for China, bank funding, dwelling prices, and the risk of another crisis. But he doesn’t just present the positive angle to the story but also addresses “what if” questions such as the response to a serious slump in China.

Whether you are pessimist or optimist, the Reserve Bank Governor’s speech is worth a read. In his usual impassioned and clinical way he addresses issues calmly and rationally. The overwhelming conclusion being that Australia is well placed to deal with any shocks.

The Reserve Bank Governor reportedly noted that policy settings are about right. While that doesn’t preclude a rate cut in August, the factors would need to present, such as further instability in Europe and a low domestic inflation result. CommSec is still pencilling in a rate cut over the next few months.

“The Lucky Country”

One point the Governor has sought to emphasise is that our good economic circumstances are not owed purely to luck. That is, we went into the crisis in good shape, with the flexibility to cut rates and with a solid financial system. In essence we made our own luck.

The Reserve Bank Governor also wanted to dispel myths about the Chinese economy. He noted that the recent slowdown was planned by the Chinese authorities and is very much just a cyclical slowdown, rather than something more long-term or structural.

“The data are quite consistent with Chinese growth in industrial output of something like 10 per cent, and GDP growth in the 7 to 8 per cent range.”

Governor Stevens also sought to dispel myths about Australia housing prices. Rather than being expensive, he believes that housing affordability is the best since 2002:

“Australian dwelling prices on a national basis have in fact declined and are now about where they were in 2002. That is, housing has become more ‘affordable’. Four or five years ago we supposedly had a housing affordability ‘crisis’. Now it seems that the problem some people fear is that of housing becoming even more affordable.” (his emphasis)

On the question of whether housing is over-valued, his arguments show that he isn’t convinced:

“But it has to be said that the housing market bubble, if that’s what it is, seems to be taking quite a long time to pop – if that’s what it is going to do. The ingredients we would look for as signalling an imminent crash seems, if anything, less in evidence now than five years ago.”

In terms of bank funding vulnerabilities, again the Reserve Bank Governor says there are grounds for optimism:

“A reasonable conclusion is that the degree of vulnerability to a global panic of any given magnitude appears to have diminished, rather than grown, over the past few years.”

The Governor has highlighted a number of developments that have worked to strengthen our economy:

“Some of the adjustments we have been seeing, as awkward as they might seem, are actually strengthening resilience to possible future shocks. Higher – more normal– rates of household saving, a more sober attitude towards debt, a re-orientation of banks’ funding, and a period of dwelling prices not moving much, come into this category.”

So what would happen if there was a slump in China? The following highlights the clinical way that the Governor addressed potential risks in the speech:

“If the thing that goes wrong is a serious slump in China’s economy, the Australian dollar would probably fall, which would provide expansionary impetus to the Australian economy. But more importantly, we could expect the Chinese authorities to respond with stimulatory policy measures. Even if one is concerned about the extent of problems that may lurk beneath the surface in China – say in the financial sector – it is not clear why we should assume that the capacity of the Chinese authorities to respond to them is seriously impaired. And in the final analysis, a serious deterioration in international economic conditions would still see Australia with scope to use macroeconomic policy, if needed, as long as inflation did not become a concern, which would be unlikely in the scenario in question.”

What are the implications for investors and interest rates?

The Reserve Bank’s Governor’s speech is designed to outline the facts rather than fallacies about Australia’s economic performance and the potential to handle future shocks. If businesses and consumers become more confident about Australia’s position, they will be more likely to get back to the business of spending, investing and employing.

The Reserve Bank Governor reportedly noted that policy settings are about right. While that doesn’t preclude a rate cut in August, the factors would need to present, such as further instability in Europe and a low domestic inflation result. CommSec is still pencilling in a rate cut over the next few months.

The Chinese purchasing managers’ index result is encouraging. The Chinese economy is lifting after the self-imposed slowdown. But more importantly authorities are well placed to provide stimulus to the economy with inflationary pressures now more settled and activity only recovering slowly at this stage.

25 July 2012

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