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Wednesday 14 June 2017

The long slow march to zero (part 13)

Construction to leave a hole

Not a blog title that I've felt the urge to us for more than a year now, but, hey, I thought it might be time to resurrect it!

The latest Australian National Accounts showed that the economy grew by a moderate 1.7 per cent over the year to March 2017, marking an impressive 103 quarters since the last recession

In recent times, economic growth has become rather reliant on certain sectors of the economy, such as finance/insurance and construction, while the contribution of manufacturing has been in a sweeping structural decline. 

Stripping out a few of the key industries of the economy and plotting them as a share of gross value added, we can see the structural decline in manufacturing more clearly, denoted by the red line in the chart below. 

Arguably the most interesting development has been the increased contribution from construction as the resources boom really hit its straps from around 2003 (as a share of GVA construction increased from a nadir of 5.2 per cent in 2000 to a peak of 8.5 per cent in 2014).

As the resources construction boom has turned down, so too has the contribution from construction, but so far only back down to 7.6 per cent.

The reason for this is that more than 1.1 million Australians have remained employed in the construction industry, about three quarters of whom are accounted for by the residential sector.

In short, employment has been held aloft by an apartment construction boom focused upon Sydney, Melbourne, and Brisbane. 

The residential construction cyclical upswing is set to turn forthwith, however, which may well mean that interest rates will continue to fall in due course. 

Arguably interest rates should already have fallen further, but there is a widely held view that if the Reserve Bank of Australia (RBA) was to inject more credit into the economy, too much of it would end up being directed into residential housing.

Broad money

It may be worth recapping that the mandate of the RBA cites an inflation target for consumer prices set at 2 to 3 per cent per annum, but the core rate of inflation has been tracking under this range for some time now.

It's generally agreed that a moderate rate of consumer price inflation is the best outcome for an economy, while deflation is seen to be an economic evil (since production slows and demand for goods drops, eventually resulting in rising unemployment).

Persistent and moderate inflation can only really be achieved over the long run if a sufficient quantity of new money is created, expanding the money supply. 

The thing is, in a capitalist economy - other things being equal - the price of some goods should get cheaper over time, through improved productivity and as businesses become more efficient.

When I was at Uni, for example, my housemates and I had to club together what now seems like a ridiculous £400 for a television and video player that you would probably laugh at today (the video cassettes you would definitely laugh at). 

Partly because some goods can become cheaper, central banks may need to inject more money into the economy or expand the money supply at a faster rate than you might expect to create the desired moderate and persistent rate of consumer price inflation.

As I analyse here each month the share of outstanding credit pertaining to housing has indeed been increasing over time. 

Therefore it's likely that the RBA will want to see some of the fizz come out of the Sydney and Melbourne property markets before considering cutting the cash rate further. 

Another issue that could cause a delay is that there may be some very sharp increases in electricity prices  this year - perhaps up to 30 per cent for some eastern seaboard consumers - pulling the headline rate of inflation higher. 

Further injection

JP Morgan noted today that it sees the RBA cutting interest rates twice in the first half of 2018, while acknowledging that housing markets may need to cool first.

If it transpires then the cash rate would have fallen to a record low of 1 per cent, which some believe is Australia's version of a zero interest rate policy.