Why the Reserve Bank has little option but to cut interest rates

Finally. After more than six months of conjecture and on-again off-again signals, interest rates are about to start a descent.

With an election due sometime in the next few months, the decision has become mired in politics and some of those arguing against a February cut appear to be pushing an ideological rather than an economic agenda.

What should be remembered is that, elections aside, the Reserve Bank now operates under just two mandates: to maintain price stability and full employment.

Over the course of the past three years, it has done exactly that. It has pulled off the near impossible by keeping unemployment at close to record lows as inflation has decelerated back into the target band.

That deceleration became more pronounced in the second half of last year as the economy slowed to a crawl under the weight of 13 interest rate hikes.

GDP is barely growing and is only in positive territory due to population increase and government spending. Added to that, retail sales are abysmal, insolvencies are at record levels and households have suffered the biggest fall in disposable income in more than half a century.

Never has a rate cut been more justified or necessary.

Headline inflation now sits at just 2.4 per cent, well inside the target band. And core inflation, at 3.2 per cent, is now perched slightly above the band.

That core inflation number has been the primary argument for not cutting rates. But if you look at its descent over 2024, it is clear that unless the RBA acts now, it runs the risk of waiting too long.

In the December quarter, core inflation came in at just 0.5 per cent which, if you annualise it, comes in at just 2 per cent, smack bang at the bottom of the RBA’s target range.

Statistically, that’s not a particularly rigorous way of analysing the result. But if you annualise all four of the quarterly numbers from last year, there’s a clear trend.

Core inflation has dropped rapidly, more than halving from an annualised 4.1 per cent in March, with the biggest falls occurring in the second half of the year.

Who’s playing politics?

Among the increasingly desperate arguments to not cut is that this meeting will be the final one under the RBA’s current make-up and, as such, this board should just sit on its hands and wait for the new board to decide what to do.

So much for board member responsibility.

Then there is the well-worn but increasingly feeble argument that there aren’t enough people out of work. Oddly, no-one pushing that line has yet to selflessly volunteer to join the ranks of the jobless.

It’s based upon a theory that harks back to the late 1950s called the Phillips Curve which postulates that inflation and unemployment are inversely related. High unemployment supposedly keeps prices in check while low unemployment fuels inflation.

Numerous economists including Milton Friedman have honed their reputations and won accolades for refining the relationship, to the point where you can calculate almost the exact number of people needed to be put on the scrap heap to keep prices from rising too quickly.

Guess what that magic number is. You don’t know? Well, you’re in good company because neither does anyone else, including Michele Bullock or Jerome Powell. Because the problem is, the theory no longer holds or, if it does, only intermittently.

Here’s a US Federal Reserve paper entitled Who Killed the Phillips Curve?

Or try this one or perhaps this.

But still, despite all the evidence along with explanations as to why the relationship has shifted, many of our leading economic minds persist, pushing the line that we need to shed jobs even though it runs counter to their own lived experience and basic logic.

Just think about it. If unemployment is too low, as they argue, then the inflation rate wouldn’t be dropping. But it is. Therefore, ipso facto, the unemployment rate is not too low.

Why Australia was smacked harder than other developed nations

Truth may be the first casualty in war but when it comes to election campaigns, it was buried long ago.

The soft campaigns have already begun but the wild claims have yet to get underway in earnest.

This time around, shell-shocked voters, scarred by the past few years of barely scraping by, will be looking for salvation.

Just wait for the slogan that promises a “reduction in the cost of living”, hinting vaguely at reduced prices down the track.

But that’s a promise that can’t be kept because the only way you can reduce the cost of living is to put the economy into a nosedive and engineer deflation. If that happens, we’ll all be in deep trouble.

Unfortunately, while inflation is on the mend, the cost-of-living crisis is nowhere near being solved. For inflation doesn’t measure prices; it simply is a gauge of how quickly prices are rising.

Regardless of who wins at the polls, everything will remain horribly expensive at least until wage rises restore spending power. And that could take years, possibly even until 2030.

It is a problem that hit Australia much harder than other countries.

This is a graph from the OECD which measures household disposable income. While everyone suffered through the pandemic, the US (green line) and the OECD nations (purple line) all bounced back. We didn’t.

Our household income (blue line) kept heading south to the point where we had the biggest fall in living standards in more than 50 years.

The primary reason is that, unlike the rest of the world, our mortgages are largely variable. Even our fixed-rate loans are only for a couple of years. By contrast, American home owners largely have a fixed rate for the life of the loan.

So, when the Reserve Bank pushes up interest rates, they immediately hit Australian households.

Hit us they did. That’s why we’ve dramatically scaled back on spending and why the economy is flatlining, more-so than anywhere else.

More to come

If the RBA does push through a February cut, it won’t be the last.

Instead, it will be the start of a longish period of readjustment to help restore household finances and get the economy back on track.

Along with a 96 per cent chance of a cut — almost a unanimous view — many believe there will be two and possibly three cuts this year.

But it won’t be a quick fix and it won’t do the job alone.

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For most of the past year, wages have begun to outpace inflation as price rises have eased.

Nevertheless, inflation-adjusted wages are down 7 per cent from their peak and are now at levels last seen about 14 years ago.

It is another graphic illustration of just how the relationship between inflation and jobs has broken down. Despite unemployment dropping as low as 3.5 per cent after the economy emerged from lockdowns, wages simply couldn’t keep pace with soaring inflation.

That’s because the labour market isn’t a free market. It’s tightly controlled, with wage rises restricted and industrial disputes limited — something our economics brains trust appears to have overlooked.

And it’s why the RBA should begin its much-awaited cutting cycle to bring the Australian economy back to life.