Tuesday, July 28, 2015

Low growth ahead. Why the Reserve Bank won't ride to Abbott's rescue

Don't expect another cut in interest rates

It's true that Reserve Bank governor Glenn Stevens is holding open the possibility of further cuts. It remains, he said last week, "on the table". But further cuts are far less likely than they would have been, for three reasons also spelled out in last week's speech.

One is that the Australian dollar has plunged to about where the Reserve Bank wants it. In the past Stevens has said it was "too high", overvalued, "and not just by a few cents".

Invited to repeat his comments last Wednesday he said merely that the dollar was "adjusting, as you would expect".

He had previously nominated a target of US75¢. The dollar has since fallen to US73¢, a six-year low. If the wish for a much lower dollar was ever a secondary consideration in Stevens' decisions about interest rates, it isn't now.

Another reason is his fear there will come a point when further cuts encourage dangerously reckless borrowing. "Monetary policy works partly by prompting risk-taking behaviour," he said in Sydney last week. "Beyond a certain point, it can be dangerous."

Although that hadn't been the case to date, Stevens said in the future he would need to look more closely at whether further cuts boosted "sustainable economic growth rather than simply boosted growth".

And another reason – the most important – is that the bank is in the process of lowering its ambition. It is preparing to accept a more modest rate of economic growth than it was only months ago.

Let me explain...

Next Friday the bank will release its latest forecasts for economic growth. It is likely to revise them down, as it has done in each of the past four quarters. This time the revision should bring them so low as to be inconsistent with its widely understood target for economic growth, which is somewhere between 3 and 3.25 per cent.

The bank calls its target "trend growth". The trend for the past decade or so, it is thought to be the sweet spot above which inflation starts to climb and below which unemployment starts to rise.

The bank cuts, or lifts, interest rates until it gets growth back to trend, or so it had been thought. Until Wednesday.

Stevens began his discussion of the trend by pointing out that, oddly, jobs growth has picked up this year even though growth had been, "according to the available statistics, below trend".

It's been well below trend at present 2.3 per cent, although currently forecast by the bank to return to 3.25 per cent in 2016-17 – and it defies conventional wisdom for the unemployment rate to be falling, as it has been all year, while growth remains anaemic.

Stevens said it was possible that either the employment statistics or the growth statistics were wrong. It was possible too that our present unusually restrained wage growth was keeping people in work who otherwise be out of work.

But then he raised another possibility: that the actual trend is "lower than the 3 per cent or 3.25 per cent we have assumed for many years".

If so, the Reserve Bank would have no reason to cut rates from here on, even if it was to forecast growth never reaching 3 or 3.25 per cent, as it may be about to do next Friday.

This isn't as bad as it sounds, he hastened to add. What matters for ordinary Australians is growth per head. This needn't dip much as total growth dips because Australia's population growth is growing more slowly.

It is a measure of how new the governor's thoughts are that until now the bank's quarterly roundup of economic statistics hasn't even included growth per head. The update is scheduled for next Wednesday.

If not 3 to 3.25 per cent, what is the bank's new growth target? Modelling by former Reserve Bank official Paul Bloxham suggests it's 2.50 to 2.75 per cent, which is not too far away from what we have now. He believes that as things stand, growth any higher than 2.50 to 2.75 per cent will push up inflation and not be welcomed by the bank.

If so, an end to rate cuts may be the least of our problems. The budget deficit forecasts are predicated on a rebound in economic growth to 3.25 per cent. If the rebound doesn't happen, if growth misses the target by 0.50 percentage points, future budget deficits will be far deeper than forecast in May – as much as $10 billion per year deeper by 2020 and $30 billion per year deeper by 2025, according to the parliamentary budget office.

Extra tax, whether from the GST or somewhere else, will become essential. Tony Abbott used to say that the former government didn't have have a revenue problem, it had spending problem. Whether that was true or not, it won't be true for Abbott now. He'll have to raise revenue from somewhere.

His efforts to do it will probably depress growth further. The Reserve Bank has made it clear there are limits to how much it can help him out.

In The Age and Sydney Morning Herald

Tuesday, July 21, 2015

Done right, negative gearing can work

Spot the odd one out:  the treasury's tax discussion paper, the Murray report into the financial system, the Organisation for Economic Co-operation and Development and the Reserve Bank have all come out in favour of a re-examination of negative gearing or the capital gains tax concession that underpins it

It's only the government that is holding back. "We're not going to fiddle with negative gearing because the last time a Labor government fiddled with negative gearing, it destroyed the rental market in most of our major cities", a defiant prime minister told a Liberal state council meeting last week.

Never mind that he's wrong. Readily available graphs show that rent increases slowed in more cities than they rose when Labor temporarily wound back negative gearing in the mid 1980s. Never mind that in every city rents have increased faster since the reinstatement of negative gearing than they did in the years when it was wound back. Never mind that the explosion in negative gearing since the turn of the century has helped push house prices beyond the reach of genuine buyers.

Negative gearing and the associated capital gains tax concession aren't the only reason houses prices are soaring. But they are part of the problem, a part that can easily be dealt with without hurting renters or anyone else (including investors presently negatively gearing).

Tony Abbott's stand is more about differentiating himself from Labor than it is about getting people into houses. It's about rhetoric rather than results.

In order to examine why house prices are soaring beyond the reach of ordinary Australians it's necessary to first establish that they are. After all, didn't research conducted within the Reserve Bank unveiled this month conclude that house prices were actually undervalued?

Last week's Reserve Bank submission to the parliament's home ownership inquiry shows typical homes now cost more of the typical wage than ever before – in excess of five times the average disposable income. Back in 1990 they cost three times the average disposable income. Before negative gearing took off at the turn of the century they cost four times the disposable income.

But the RBA says that doesn't necessarily mean houses are less affordable...

Record low mortgage rates have pushed down the cost of repayments to well below their decade long average. Compared to renting, buying is exceptionally cheap according to the preliminary research. Taking into account the high likelihood of continuing low rates the research finds that, compared to renting, paying off a home is cheaper than it's been in three decades.

Except that that's not the end of it. Cheap repayments aren't much help if you can't afford the deposit.

The RBA's submission shows that the typical cost of a deposit is higher than it has ever been, around 100 per cent of average disposable income – or it would be, were it not for the fact that many lenders have relaxed their standards.

But it says even taking into account of relaxed standards, deposits are more expensive than they used to be, forcing Australians without very good access to cash to either postpone or forget about buying a house. Typically these people are young, and without well-off parents to help them out. High prices are entrenching inequality.

A frightening graph in the Reserve Bank's submission shows the home ownership rate among middle-income Australians has slid since the turn of the century while the rate among high-income Australians has held up.

The turn of the century is when prices took off, climbing faster and for longer than ever before. A few months earlier in September 1999 the Howard government excluded from tax half of every capital gain, making negative gearing suddenly much more attractive (for shares as well as property). Until then, if you used losses to cut your taxable income you still had to face tax when you eventually sold. Afterwards you could deduct 100 per cent of your annual losses but be taxed on only 50 per cent of your eventual profits.

An extraordinary one in 10 Australian taxpayers became negative gearers. In order to get the properties they had to push up prices and elbow out would be owner-occupiers. Sure, they could have built new homes rather than buy existing ones, but they lacked the patience. Fourteen out of every 15 dollars borrowed for investment housing is spent on existing homes.

Labor is considering a proposal to put negative gearing to work. It would allow existing negative gearers to keep doing what they are doing. No-one would be rushed into selling anything. Anyone who wanted a new negatively geared property would have to build it. It's the same rule we apply to foreign investors. They are allowed to build but not to buy. The Melbourne-based McKell Institute reckons it would boost the supply of new houses by 10 per cent while boosting the annual tax take by $1 billion.

Labor ought to be able to sell it. It can rely on the treasury, the Reserve Bank, the OECD and the financial system inquiry for tacit support. Only the government is out of step. Labor can position itself as the party of more affordable housing.

In The Age and Sydney Morning Herald