Europe goes down

Last month, I gave 30 per cent odds for a December rate cut, but with mounting uncertainty in Europe I increased it to a 45 per cent probability.

On the one hand, Australian economic data have been somewhat better and towards the end of November, the flow of commentary from the Reserve Bank (RBA) suggested it was in no hurry to cut rates.

But with the news out of Europe getting bleaker and bleaker, and wages data in Australia coming in on the soft side, when you balance it all out, the chance of a December rate cut had increased.

The RBA has been very concerned about the mining boom triggering a wages breakout at a time when productivity growth is very soft.

What the wages figures actually show quite clearly, however, is that wages growth is quite benign.

There is very little evidence that the mining boom and the shortage of skilled labour have flowed through to a wages pick-up. The most recent numbers show wages growth is sliding back towards the three per cent level.

It’s often thought that it’s when you are above four per cent it starts danger signals flashing for the RBA.

We were heading in that direction six to 12 months ago but that is no longer the case. We seem to be retreating from that, so the wages situation is pretty benign and that at least removed one concern for the RBA.

In early November, the RBA could point to a pick-up in financial markets, following the turmoil that we saw into early October, but that seems to be no longer the case.

Financial markets are weakening again in response to what’s going on in Europe.

So even though the wages figures look pretty benign, that’s providing the RBA with flexibility on the interest rate front as it suggests a relatively benign inflation outlook.

However, the deterioration in Europe suggests a greater risk to the global economy and the RBA has previously nominated Europe as the biggest risk for Australia.

I think Europe is looking pretty terrible at the moment.

The question is whether Europe is going to have a mild recession or a deep one.

Unfortunately, we have already seen problems spread further through Europe. Italy and Spain have been dragged in, with their bond yields pushed higher such that they are at levels that are unsustainable in the long term.

This could mean they end up having insolvency problems, much like those of Greece.

Even more worrying is that we’ve seen bond yields in countries like France and other AAA-rated countries across Europe, such as Finland and the Netherlands, pushed higher.

It’s looking worse day by day.

If Europe is plunged into a deep recession, the impact on Australia would take about three to six months to flow through, just as the GFC didn’t really start affecting trade until the early part of 2009.

But you would see an almost immediate effect in terms of financial markets.
 
European banks are looking to sell their operations in Australia or wind them back, which is acting as a significant drag on the availability of credit.

And of course we have seen an immediate impact on business and consumer confidence.

It’s hard to see Australian consumers and businesses spending aggressively when there is this constant drip flow of bad news coming out of Europe.

All these things suggest that while it may take a while for the trade impact to hit, the impact on financial markets and confidence would become apparent fairly quickly. I suspect that the RBA won’t wait to see the full depth of a recession in Europe before acting.

If it looks like it’s falling apart, they would take measures and step in fairly quickly, and then rather than talking about 25 point cuts we’ll be looking at 50 basis point cuts or more.

Shane Oliver is AMP’s chief economist