Why The RBA Uses The Terms of Trade Indicator… And Why You Should Too — ASXnewbie.com
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Why The RBA Uses The Terms of Trade Indicator… And Why You Should Too

Today, the Reserve Bank of Australia meets for the first time this year. I’ve spent the last week reading the papers as they make a case for a rate cut this week.

Most papers are keen to analyse the data you’re familiar with, like gross domestic product, retail trade data and inflation-related data. But they ignore another measure of our economy that I believe is a very good indicator of the action the RBA will take on rates.

The thing is, when this economic indicator goes ‘up’ interest rates tend to follow it higher… and when it goes south… well, a cut in the cash rate isn’t far behind.

Glenn Stevens, the governor of the Reserve Bank of Australia, mentions the ‘terms of trade‘ when a policy decision has been made. At the September 2011 meeting, he said it’s ‘…now at very high levels and national income has been growing strongly’.

And he referred to it again when the RBA cut rates at the December meeting: ‘The terms of trade have now peaked and will decline somewhat in the near term, but they remain very high.’

The terms of trade simply reflects the relationship between the prices of exports and imports. So an increase in the terms of trade reveals that export prices are increasing faster than import prices.

I bring the terms of trade up because of the effect it has on Australia’s economic growth.

It’s not the standard measure of economic growth you read about in the papers – GDP (Gross Domestic Product).

The terms of trade is another economic growth measure calculated by the Australian Bureau of Statistics – Real Gross Domestic Income (Real GDI).

The chart below shows these two measures of quarterly national income plotted against each other. GDP is the dark line and Real GDI the light line.

Percentage changes

As you can see, when factoring in changes to the terms of trade, Australia’s economic growth is much more volatile. Since 2003, it’s been much stronger than the standard GDP measure would suggest.

Now, look at the chart again and focus on the last few years. Real GDI plummeted in 2008 and early 2009 as China’s economic growth slowed and commodity prices collapsed. But by the time China’s stimulus worked its way through the system, in addition to Australia’s own stimulus spending, Real GDI rebounded strongly.

On this measure, by mid-2010, Australia was experiencing its strongest rate of growth since 1997. Now that may seem absurd given the weak conditions experienced across large parts of the economy.

And yesterday’s retail trade data was the worst in decades.

Despite manufacturing data in January suggesting minimal growth, Toyota sacked 530 Australian workers. Reckitt Benckiser, the company that owns brands Mortein and Dettol shifted its production lines offshore, along with almost 200 jobs. And Westpac shed 560 workers.

And that was just one week!

But that growth in Real GDI was thanks to a soaring terms of trade. And the benefits were felt almost exclusively in the resources sector.

Governor Glenn Stevens is always talking about the terms of trade and its impact on national incomes. So I reckon the Reserve Bank looks very closely at Real GDI when setting interest rates each month.

That’s why rates were slashed in 2008 and then increased more than anywhere else in the developed world in 2010, in line with the sharp downturn and quick reversal you see in the chart above.

If we look at the fourth quarter data (not charted) it tells us that export prices fell 1.5%, meaning the peak in terms of trade is now behind us.

As a result, Australia’s Real GDI – our ‘income’ – has fallen. The further our Real GDI falls, the more likely the RBA will lower interest rates to offset the fall in national income.

You make think falling interest rates is good news. And that’s the way the media will portray it. But it wasn’t good news in 2008 and it won’t be in 2012 either. Falling interest rates are a sign the Reserve Bank has run out of ideas on how to keep the economy moving at the same speed we’re used to. And you should get ready for it to falter.

Greg Canavan
Editor, Sound Money. Sound Investments

This article is contributed by Money Morning. Click Here to Subscribe to their free newsletter.

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