Economic uncertainty is on the rise, and that could see the RBA cut rates again

Photo by Michael Dodge/Getty Images

It’s unlikely to come as a surprise to anyone paying attention to financial markets, but economic uncertainty is on the rise in Australia.

This is no better demonstrated than in the chart below, supplied by the ANZ. It’s the bank’s newly-created “Economic Uncertainty Index”, a concoction of economic policy uncertainty, financial measures of uncertainty in Australia and financial measures of uncertainty emanating from the rest of the world.

According to Giulia Specchia and Kieran Davies, economists at ANZ, the recent spike reflects some uncertainty about the upcoming federal election and possibly concerns over the possible exit of the UK from the European Union.

The pair note that foreign shocks seem to be a major driver of uncertainty in Australia, accounting for about 70% of its overall movements. Again, not all that surprising given Australia, as a small open economy, is greatly impacted by events in larger economies.

The global financial crisis, European debt crisis and concerns over the Chinese economy are just a few of the examples in recent years that underline this point.

So why is it important, particularly given it’s only slightly above the indices long-run average?

Well, putting it bluntly, when uncertainty rises significantly, economic activity and interest rates tend to move in the opposite direction.

Specchia and Davies explain:

    We simulated the impact of a shock of one standard deviation to the uncertainty index. This is a similar-sized shock, for instance, to what happened to uncertainty during the market turmoil in February 2016.

    Our results show that following a temporary increase in uncertainty:

  • Consumer confidence edges down by about 1½ points over the two months after the shock, with the effect fading over subsequent months.
  • Business sentiment falls sharply, down about 2 points over the two months following the shock, although the impact also fades over the following 3-4 months.
  • Firms’ willingness to hire edges down, with ANZ job ads down 0.6% one month after the shock, although after six months the effect is more than reversed.
  • The cash rate drops by a bit less than 25bp by about 3 months after the initial shock, which is about a month after the decline in business and consumer confidence. The cash rate tends to remain lower for at least 12 months.

It’s fairly self explanatory. Increased uncertainty hurts confidence. That in turn has a negative impact on economic activity and, as a result of the domino effect, the RBA tends to reduce interest rates.

Rinse and repeat is the indisputable trend of recent years, something that goes some way to explaining why interest rates, not only in Australia but globally, currently sit at record low levels.

Although economic uncertainty remains relatively low, particularly to recent years, Specchia and Davies believe that the recent spike may extend in the months ahead, potentially placing pressure on the RBA to cut rates again.

“With the index slightly above its long-term average in May, we think it has the potential to pick up further in June given the number of events that may increase uncertainty over the coming months,” they say.

“These include foreign-related shocks (eg the upcoming ‘Brexit’ referendum, ongoing worries over China and emerging markets), while others are domestically driven (eg the Australian federal election in July).”

The first test this theory will face will be the UK Brexit vote on Thursday, with the results likely to be known in Australia by lunchtime Friday.

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