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A Rise Too Far?

Australia | Mar 04 2008

By Greg Peel

The Reserve Bank of Australia  has just increased its target rate by 25 basis points to 7.25%. Inflation was cited as the overwhelming reason. Last month the US Federal Reserve cut its target rate by 50 points, following a 75 point emergency cut previously. This took the US rate to 3.00%. While the Fed is cognisant of inflation, it is currently more concerned with the slowing US economy.

The Australian and US economies are not chalk and cheese. They are both suffering the same inflation spike, the same fallout from the credit crunch, the same low levels of unemployment, and while the preliminary figure for US first quarter GDP growth is 0.6%, Australia’s is 0.8%.

So why is the US aggressively cutting rates while Australia is raising? Well for starters, those two 4Q GDP figures are measured differently. Australia’s result is specifically for the quarter alone, bringing the annual rate down to 3.9% from 4.3%, while the US number suggests annual economic growth fell from 4.9% in the third quarter to 0.6% in the fourth. The US is suffering from a fall in average housing prices in excess of 10%, while nationally Australia’s average housing price is still on the rise.

The Fed has decided the economy is the most immediate problem, and inflation will just have to wait. America has suffered a bursting of the bubble. Australia’s economy is still too strong, adding to inflation pressures, and the RBA wants to pull on the reins. The US stands ready to re-raise rates as soon as there are signs the economy has stabilised. Australia stands ready to stop raising rates as soon as there are signs demand growth has eased. Although both countries have suffered from falling stock markets, Australia is yet to see the bursting of a credit bubble.

The RBA raised rates because of inflation. The latest CPI data were indicative of the current problem, and a continuing increase in domestic demand in the face of overstretched capacity, as well as ongoing shortage of labour seal the deal. Economists have been expecting another rate rise in May is also possible, particular in the face of ever-soaring commodity prices. Today brought some conflicting data – the current account deficit blew out from $16.4bn in September to $19.4bn in December due to an imbalance of spending on cheap imports and loss of export trade due to adverse weather conditions. This is equivalent to removing a full 1% from GDP growth. However, government spending also jumped significantly, adding back 0.5% to GDP growth.

January retail spending surprised economists with a flat result, when a 0.5% increase was expected. It appears higher food and petrol prices, and higher mortgage payments, have finally bitten. The RBA noted in its statement accompanying today’s decision:

“There is tentative evidence that some moderation in household demand is beginning to occur, with business and consumer sentiment softer recently, and household credit demand slowing somewhat. The extent of that moderation is uncertain, however. As the board noted last month, a significant slowing in demand from its pace of last year is likely to be necessary to reduce inflation over time”.

In other words, “We may not necessarily have to raise rates in May but don’t count your chickens”.

The Fed, on the other hand, has indicated pretty clearly it will be dropping its rate another 50 points this month. Some are even suggesting 75 points.

While it is pretty clear to everyone now that the bursting of the housing bubble in the US has precipitated the credit crunch and probable US recession, a glance at the next graph might just help in realising why the US housing bubble actually burst.

The graph comes from the latest edition of the DebtWatch report published each month by Dr Steve Keen, Associate Professor of Economics & Finance at the University of Western Sydney. Dr Keen notes that mortgages are serviced within an economy through income, and that income is derived from the selling of goods and services. Thus the ratio of asset prices (in this case a house) to consumer prices is “the best measure of how hard or easy that is to achieve”.

Good grief. Was that a housing bubble or was that a housing bubble? And how far can it go back down? Now let’s overlay Australia:

Ye Gods. This is the “real” house price comparison starting at an equivalent 100 base in 1890. If we re-base back to 100 in 1987 – the year of the stock market crash – we find that Australia recently led the US in both the rally and peak in house prices, but whereas the US has now turned and begun falling precipitously, we’re now going back up. Where does it end?

Australia’s household debt level was half that of the profligate America’s in 1990, but has now caught up. Thus Dr Keen suggests the housing bubble in Australia is “financial” (chasing higher prices) rather than “real” (solely demand driven). “If so,” says Dr Keen, “we face just as serious a potential downside to house prices as does America. If not more so.” The reason it hasn’t yet happened in Australia can likely be put down to the China effect (driving Australia’s commodity economy) and very different mortgage default laws (in a nutshell, Americans can walk away while it takes months to move to mortgagee sale in Australia).

Now using the same CPI-deflation method, let’s look at the stock markets. Here’s the US:

Oh dear. Now let’s overlay Australia:

Now that looks much better. As Dr keen points out, the Australian stock market bubble has been nowhere near as dramatic as that of the US. At a base of 1984 (when the ASX began keeping the data) the Dow Jones was 2.3x that of the All-Ords, but it hit 5.2x in the tech bubble Australia never really had. When both indices peaked last year, the ratio had fallen back to 3.2x, but this still suggests Australia’s leverage-driven market has been more speculative than the US in the last few years. (Witness recent spectacular corporate house-of-cards collapses). Note the recent trend indicators on an absolute comparison:

 

Dr Keen suggests neither the RBA nor Fed deserves any accolades for their respective management of the financial system recently. They have both sought to control commodity inflation (quietly tightening monetary policy) while allowing asset price inflation (houses, stocks) and debt inflation (mortgages, leveraged loans) to run rampant. Now they are diverging in strategy, but both still have an obsession with keeping commodity prices under control.

Of the two, Dr Keen believes the Fed “clearly appears more realistic” about the current economic threat, even if it was the Fed that allowed the bubble to happen in the first place. “Now is not the time to be fighting commodity price inflation,” says Dr Keen, “while ignoring both debt and asset price inflation”.

Dr Keen has thus been a critic of the recent RBA rate hikes. The more the RBA concentrates on bringing down commodity inflation, the more likely is a crunch about to hit in asset prices. So far the stock market has copped a beating, but house prices haven’t.

CommSec chief economist Craig James believes the rhetoric in the accompanying RBA statement (as noted above) suggests the RBA will now “pause for a few months before lifting rates again”. It’s time to let the rates do their work. From the statement:

“Having weighed up both the international and domestic information available, the Board conluded that a further tightening in monetary policy was needed to secure an inflation rate of 2-3 per cent over time. As a result of this and earlier actions, and rises in borrowing costs which are ocurring independently of changes in the cash rate, the overall tightening in financial conditions since the middle of 2007 is substantial”.

Forex traders clearly agree this rise may be the last. The Aussie has fallen a full US cent this afternoon.

Craig James’ colleagues at Commonwealth Research have also weighed into the argument, suggesting there is a “tipping point” in the level of interest rate where household spending decisions are affected, based on debt servicing ratios. While some tentative signs of caution amongst Australian consumers have already emerged, that tipping point is calculated by the economists to be 7.25-7.50%.

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