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Credit Suisse tips up to three RBA cuts to protect overgeared households

Australian households are overgeared and the Reserve Bank of Australia might have to cut interest rates up to three times to ward off a dramatic deleveraging event in the economy.

Credit Suisse strategist Damien Boey argues the output gap in the economy is widening at a time when households are past the "break-even" level of leverage.

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Rates on hold for Christmas

The Reserve Bank has left rates on hold until at least February. Peter Martin explains why.

In fact, at a gearing ratio of 26.87 per cent, they are well beyond the 17.86 per cent level at which residential housing investment stops being loss-making, he estimates. The jobless rate will be updated on Thursday; it was 5.6 per cent in October when overall growth fell short of expectations.

To bring households back into sustainable territory, the RBA either has to force deleveraging, which would pose a shock to the economy, or raise the level at which households break even by lowering the cost of debt.

Most forecasters see the RBA staying on hold, and the US Federal Reserve forecasting a faster pace of rate hikes in 2017 will only contribute to this view, as that's likely to keep a lid on the Australian dollar, which in turn takes the pressure off the local central bank to weaken the currency by cutting rates.

Futures imply the cash rate will be at 1.49 per cent in 12 months, the median economist forecast is for a cash rate of 1.5 per cent in the fourth quarter of 2017, and some observers think rate cuts are pointless and ultra-loose policy has been a failure.

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Mr Boey argues the cash rate should be at 0.8 per cent, implying almost three full rate cuts from the current level of 1.5 per cent, given he puts the output gap at 1.4 per cent of GDP and the long-term neutral rate at 2.2 per cent.

The neutral rate is the level at which monetary policy has neither a hot nor cold effect on growth.

He has become concerned about the pipeline for jobs in New South Wales and Victoria, because although they are regarded as the boom states in economic activity, they are also where house prices are the most overheated.

Key markets

"The real part that you need to protect is the NSW and Victoria labour markets. What you'll find is infrastructure work is fine and good, you're sustaining a high level of activity, but you're not growing that," he said.

"Not only are you not creating jobs in infrastructure, but you're losing jobs in housing sectors. They might try to let nature take its course for a little bit longer, but history has shown this RBA is very risk-averse [around containing unemployment]."

The Credit Suisse strategist predicts rate cuts in the first and second quarter of next year. "The question is, when you get to May, what will the federal government be doing?"

Mr Boey said the RBA's need to protect overstretched households was not one of fairness or equity. "It's an economic question," he said.

Households cannot sustain a loss-making position indefinitely, but the more central banks encourage households to take on debt, the more it erodes their spending power.

"Excessive debt is a real dampener on the economy," Mr Boey said.

By cutting rates further to ease the gearing burden, the RBA would be treading a fine line.

Balancing act

"It's a delicate balance, you don't want to help them out completely. You don't want to encourage moral hazard."

Former governor Glenn Stevens tried to warn of such risks in some of his key speeches at the bank, Mr Boey said.

"The RBA tends to cut rates when the risk of unemployment is too great that macro-stability actually now requires it," he said.

In new research published by the strategist, he suggests something changed about 2000, when the RBA was dealt an additional constraint in the form of overgearing, and the Taylor rule could not be applied as faithfully.

The rule guides where interest rates should be, but high debt levels tend to mean rates are stubbornly lower than what the Taylor rule demands. The Australian economy contracted in the third quarter and is growing at an annual pace of 1.8 per cent.

Mr Boey also contends that bonds and bond-proxy assets look attractive and offer "exceptional value" if he is right about the direction of rates.