Posts Tagged ‘Ross Gittins’

RBA’s interest rates dilemma

Wednesday, September 3rd, 2008

Yesterday was the first time in several years that the Reserve Bank of Australia (RBA) decided to cut interest rates. As you can read from the mainstream news media, this fall in interest rates is not necessarily good news. For example, Ross Gittins from the Sydney Morning Herald said in Yippee, the bad times are back,

YOU beauty. Interest rates have been cut and happy days are here again. For good measure, we’ve even got petrol prices coming down.

Sorry, don’t be too sure about that. The Reserve Bank has cut its official interest rate only because times are getting tougher.

But our loyal readers should already know about this fact long time ago. Back in July last year (2007), when the talk in the market was still about booming asset prices and inflation, we warned in Should you purchase first home whilst asset price inflation?,

… it is prudent to arrange their finances with the assumption that interest rates are going to be in an upward trend for at least in the medium term. Having said that, it is still possible for interest rates to be cut? when the economy is hit by a threat of recession or depression

While those heavy in debt would welcome RBA’s interest rate relief, there are still many unresolved complications. The most important thing to remember is that Australia’s price inflation problem is still not yet resolved. The RBA is forecasting rising price inflation till the end of the year at least. Normally, no central bank will cut interest rates in the face of rising prices. But this time, they have a bigger worry than rising prices- economic recession. In other words, Australia is facing stagflation (economic stagnation/downturn and rising prices) and the RBA is more worried about the ‘stag’ part of the stagflation. And they are betting that the ‘stag’ part will somehow resolve the ‘flation’ part.

But from what we can see, the RBA’s hands are tied. If they try to prevent the slowdown from turning into a rout by slashing interest rates aggressively, it is very likely that the Aussie dollar will continue its down trend. As we explained before in Falling currency and inflation,

A rapid depreciation of the Aussie dollar will result in rising price inflation for the same reasons stated above.

We do not envy the job of the RBA. It looks like Australia may be moving towards the same path as the US (see Supplying never-ending drugs till stagflation).

Analysing recent falls in oil prices?real vs investment demand

Saturday, January 13th, 2007

In November last year, we explained our opinions on the future of oil prices (see Is oil going to be more expensive?). Recently, oil prices had been falling very rapidly to even below US$53. Were we wrong?

Before we answer this question, we have to understand the distinction between the real and financial side of the economy. The real side where you find the physical market for goods, services and labour. The financial side is where you find the flow of financial capital, assets and payments. For example, the stock, debt and derivatives markets are part of the financial side of the economy. As Ross Gittins said in his article, Two sides to the story of nation’s rising prosperity, as the financial side grows in importance, it balloons and crowds out the real side. In Australia, with hundreds of millions more of superannuation money seeking to find a home, we can expect the financial service industry to grow even more, which means the financial side of the economy will rise in further prominence in the future.

Now, let?s go back to oil. What makes up the demand for oil? There are basically two types of demand for oil: (1) The physical demand where the real side of the economy uses for its everyday needs and (2) The investment demand where the financial side of the economy shifts the money here and there from one asset class to the other. We need to ask ourselves the following question: Has the physical demand for oil changed? Will it change in the long run?

From the International Energy Agency (IEA), we can see that world oil supply exceeds world oil demand by just around a couple of millions of barrels per day (or around 2.5% of demand). From the US Department of Energy (DOE), we learnt that,

In the AEO2006 reference case, the combined production capacity of members of the Organization of the Petroleum Exporting Countries (OPEC) does not increase as much as previously projected, and consequently world oil supplies are assumed to remain tight. The United States and emerging Asia?notably, China? are expected to lead the increase in demand for world oil supplies, keeping pressure on prices though 2030.

World oil demand is expected to increase to around 120 million barrels per day in 2025, from 84.5 million in 2006, with developing nations (notably China) capturing a mounting slice of the increase. World oil supply is expected to barely keep up (assuming that Peak Oil is not true) with the demand.

These forecasts are based on a fundamental economic assumption: ceteris paribus, which means ?everything else being equal.? But as we know in real life, things rarely happen nicely according to plan. Unexpected surprises often do happen. The biggest wild card is the geopolitical situation in the Middle East. Would the Israelis or the Americans strike Iran, resulting in Iranian retaliation by disrupting the global flow of oil? Will the US succeed in creating a viable state in Iraq or will Iraq descend into chaos, thus removing a major oil-producing nation from the equation? Would war break out in the Middle East again, destroying and damaging oil infrastructures in the region?

As we can see, the fundamentals of oil are still intact. Therefore, from what we can see, such a rapid drop in oil prices is mainly due to the change in investment demand?asset managers (we prefer to see them as ?money shufflers?) shifting their preferences from one asset class to another.

Some of the reasons given by the financial media to ?explain? the recent falls in oil prices are nonsense. For example, they blamed the warmer than expected weather in North America for the price fall. In reality, oil demand is primarily driven by transportation needs, not by winter heating needs.

One more thing: as oil prices fell because of the fall in investment demand, guess what will happen to the real demand for oil?