The first Tuesday of the month is interest rate day in Australia, the day the Reserve Bank of Australia – the Australian equivalent of the Federal Reserve – announces any changes to the official cash rate. The decision for June was to leave interest rates on hold at 2.0%.
In a situation that will feel relatively alien to readers in the US, Australian interest rates have never really been close to 0, but have been falling since late 2011 (see Chart 1).
Chart 1 – Australian Cash Rate vs. US Federal Funds Rate
What has been leading to falling rates in Australia over a period where the US has been slowly recovering and the Fed Reserve is slowly edging back to normalizing interest rate policy? As is usually the case, a mix of factors are involved.
Iron Ore and Coal Prices Return to Earth
A story that most people outside Australia have at least heard about is the large mining boom Australia has been enjoying over the past decade or so, and that it was largely driven by demand from China. What they may not know is that this mining boom has been largely driven by just two commodities (well technically three) – iron ore and coal (two types of coal – thermal and metallurgical). Chart 2 shows the prices of iron ore and thermal coal[1] in AUD/tonne since the 1995.
Chart 2 – Iron Ore and Thermal Coal Prices 1995 to Present
From this chart, we can clearly see the huge increase in prices that boosted the Australian economy. This was particularly pronounced for iron ore which went from between AU$16-AU$17 a tonne for most of the 90s to over AU$180 a tonne in 2010 and 2011.
Aside from generating huge profits for anyone who happened to own a coal or iron ore mine, what this price rise also led to was a large amount of employment in areas that weren’t just digging up the commodities themselves. This included:
- Exploration of possible new mining sites – at AU$180 a tonne everyone wanted an iron ore mine
- Building infrastructure that facilitated the large-scale digging up and exportation of these commodities – ports needed to be built and/or expanded, mining pits dug, roads paved and so on
- Providing services to mining companies – lawyers, accounts, caterers and so on
After peaking in 2010/11 though, things started to go into reverse. By late 2013, much of the investment in infrastructure had run its course and the people who were employed to build that infrastructure were no longer needed. Prices were falling, bringing into question the viability of a lot of higher cost mines (and the mining companies running these mines) set up during the boom period. In short, a lot of people formerly employed on mine sites or in mining services roles were finding themselves looking for a new job and the rest of the economy was (and still is) struggling to pick up the slack. This in part is because of the …
High Exchange Rate
For those that haven’t decided to brave the 20+ hours of flight time to visit Australia in the recent past, Australia has become an extraordinarily expensive place. Sydney and Melbourne have been consistent fixtures in the world’s most expensive cities to live lists over the past 10 years.
Most of this was driven by a very strong Australian dollar, which was in turn driven mostly by the mining boom. In addition to buyers of commodities needing Australian dollars to buy the products they wanted, Australia became the target of a large volume of carry trade with currency traders looking for a relatively stable economy to park money at a relatively high interest rate. As a result of this, at the height of the mining boom, the AUD was buying almost $1.10USD.
Since that peak, the Australian dollar has depreciated around 30% (see Chart 3), easing a lot of the price pressure. However, as of 2015, Sydney and Melbourne still rank 5th and 6th on the world’s most expensive city list, as provided by the Economist Intelligence Unit’s (EIU) bi-annual Worldwide Cost of Living report.
Chart 3 – AUD/USD Exchange Rate 1995 to Present
The RBA has publically been stating that they believe the value of the Australian dollar is too high in an attempt to talk down the value of the Australian dollar (often called ‘jawboning’) and provide a boost to the non-mining sectors of the Australian economy. They have also progressively lowered the cash rate from 4.75% in 2011 to 2.0% today, in an attempt to stem the carry trade. As we have seen, to some degree they have been successful, but the exchange rate is still higher than they (and many other commentators) believe is optimal.
Unfortunately, some bumbling on the part of the RBA (or the execution of a plan that no one else understands) has blunted some of their efforts. At the previous monetary policy meeting at the start of May, the RBA lowered the official cash rate from 2.25% to 2.0%, but removed any talk of further cuts from the publically released meeting minutes (removing the “easing bias”). Doing this then had the opposite of the desired result and caused a spike in the Australian dollar.
Chart 4 – Consumer price index; year-ended change 2000 to 2015
So why are they removing the easing bias? Why don’t they just slash rates further – after all inflation is running below the target band (see Chart 4)? The problem is they are worried about the…
Bubble in House Prices
The RBAs hesitancy to cut interest rates further is mostly due to a concern about further encouraging investment in housing and contributing to rising house prices, which look to be well into bubble territory.
For those that aren’t too familiar with Australia, particularly the modern, post ‘put-another-shrimp-on-the-Barbie’, Australia, being a property tycoon has become something of a national obsession. Home renovation shows are everywhere and are getting huge ratings. Morning news regularly holds interviews with the latest property ‘success story’.
This obsession has led to Australia becoming a world-beater when it comes to levels of household debt. The Australian Bureau of Statistics (ABS) produced a great series of charts in May 2014 showing some alarming statistics. See below for some of the highlights:
Chart 5 – Household Debt vs. Annual Income[2] in Australia 1987 to 2013
Charts 6 and 7 – Household Debt vs. Annual Income – Various Countries 2001 to 2013
After 20 years of Australians continually buying properties off each other for ever-increasing prices, funded mostly by increasing level of mortgage debt, something changed. Perhaps it was the median house price in Sydney soaring past AU$900,000 (approximately US$700,000 at today’s exchange rate). What ever triggered it, in recent months, the talk in Australia has become all about a bubble in house prices, particularly in Sydney and parts of Melbourne. The Secretary of the Department of the Treasury, John Fraser, recently became the latest high profile public figure to weigh in:
“When you look at the housing price bubble evidence, it’s unequivocally the case in Sydney, unequivocal,”
More over, he drew a direct link between high house prices and low interest rates:
“It does worry me that the historically-low level of interest rates are encouraging people to perhaps over-invest in housing,”
And there is plenty of evidence to support the notion that the rise in housing prices is increasingly due to investors as opposed to owner-occupiers (see Chart 8).
Chart 8 – Investor Housing Credit as a Percentage of Total Housing Credit 1990 to 2014
Meanwhile, belying the sparkling reputation the Australian Government has earned internationally in recent times[3], the Government has all but ruled out taking any meaningful action to reverse key policies that are currently encouraging investment in property – negative gearing and the capital gains tax concession being two of the main culprits. When asked in a recent session of question time by the leader of the Opposition Bill Shorten to respond to the comments from John Fraser, Prime Minister Tony Abbott responded as follows:
“As someone who, along with the bank, owns a house in Sydney I do hope our housing prices are increasing,”
Summing Up
All this leaves the RBA in quite a pickle. Relatively high interest rates (by the standards of developed nations internationally) continue to keep the exchange rate at higher than desired levels, which makes Australia an expensive place to do business. This in turn harms Australia’s two big non-commodity exports – higher education and tourism – just when they need to pick up the slack from a cooling mining sector. But lowering interest rates risks further fueling a bubble in house prices which the Government seems quite happy to ignore.
I don’t imagine there are too many people who would like to be in the shoes of RBA Governor Glenn Stevens right now.
Keep an eye on this space for further updates as this all unwinds.
[1] This is an example of that classic Australian trait – sarcasm
[2] Gross disposable household income received during the previous year.
[3] If anyone can find a good historical price series for metallurgical coal, I’d love to hear from you
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