"Relevant considerations of late include the fact that output is below conventional estimates of ‘potential’, aggregate demand still seems on the soft side as resources investment falls sharply, and unemployment is elevated and above most estimates of ‘natural rates’ or ‘NAIRUs’. And inflation is forecast to be consistent with the 2–3 per cent target. So interest rates should be quite accommodative and the question of whether they should be reduced further has to be on the table."
- Glenn Stevens, RBA Governor, 21st April 2015
More policy easing appears to be imminent. Interbank futures suggest there is a 70% probability of a 25 basis point rate cut at today's RBA Board meeting, while the overwhelming majority of market economists expect the RBA to ease policy today.
In December last year, in an interview to Fairfax journalists, Mr Stevens appeared to subtly acknowledge the case for more accommodative policy and laid the groundwork for a new communications strategy based on a positive narrative. The RBA would want to avoid any further rate cuts being seen to reflect a weak economy, at a time when household and business confidence were (and still are) fragile. Mr Stevens also indicated that the precipitous fall in energy prices would reduce inflation.
I believed that the benign inflation environment provided a cue for the RBA's positive narrative (see Evidente blog post, Money's too tight to mention, 12th December 2014) and expected that the RBA would ease policy at the February and May meetings, immediately following the release of quarterly CPI data (Australia is unique globally in having a quarterly CPI; most countries have monthly CPI readings). The CPI release from last week confirmed that underlying inflation remains in the lower part of the RBA's 2-3% target range and that the inflation outlook does not pose an obstacle to lower interest rates.
The RBA's communications suggest that it is carefully calibrating monetary policy in the context of its policy of least regret, which assesses the likelihood and size of costs associated with making a policy error. Most market economists, central bankers, prudential regulators and analysts are based in Sydney and Melbourne, where capital growth in housing has been strongest of late. Moreover, the recent memory of sharp falls in house prices and the contagion effects across the United States, Europe and China is clearly influencing the RBA's cautious approach. In seeking to contain the risks of speculative activity in housing, Mr Stevens is clearly wanting to avoid similar policy errors that he believes contributed to the credit boom and bust.
But the RBA is also keen to contain the costs associated with growing unemployment and under-employment. In a recent blog post (Beware of bubble talk for now - Part II, April 29th), I show that there is considerable slack in Australia's labour market: the unemployment rate of 6.1% is high amongst a group of developed countries, unemployment has remained above 6% for ten months, the longest stretch since 2003, the duration of unemployment has increased to a decade high, and the participation rate and employment to population remain low, which point to a strong discouraged worker effect.
It is telling that In the latest monetary policy minutes from April, the RBA acknowledges that labour market conditions are likely to remain subdued and that the economy is expected to operate with a degree of spare capacity for some time. In the minds of the RBA, the more serious policy error at this juncture appears to be keeping policy unchanged. Against this backdrop, market participants will need to become accustomed to more noise from the RBA and APRA about the use of macro-prudential to contain risks stemming from housing. In terms of timing, the Board members also saw benefits in waiting for more data, including on inflation.
In the likely event that the central bank cuts the Overnight Cash Rate today to 2%, investors' focus will inevitably shift to what next? Due the RBA's concerns about housing, I expect that the policy rate will remain on hold for the remainder of the year, because the central bank will want time to assess the impact of the two rate cuts. My expectation is that the statement accompanying today's decision will therefore likely quell expectations of another rate cut in the near term, which will provide some support to the Australian dollar.