The reluctant rate cutter reflects on his legacy

In what was close to a line ball decision - according to market economists surveyed and Interbank Cash Rate Futures - the RBA Board cut the official cash rate (OCR) by 25 basis point cut to 1.75%.  This extends the current easing cycle to 55 months, with the OCR now 300 basis points below the start of the current cycle in November 2011. 

The reluctance of the consensus to embrace the prospect of a rate cut has some justification.  The RBA Governor, Mr Glenn Stevens, has developed a reputation as a reluctant rate cutter during the latter part of his tenure and his communication has been confounding at times.  For most of 2014, the RBA used the language that interest rates would remain stable for an extended period, only to surprise economists by easing policy twice in the first half of 2015.  In 2012, there was the widely cited speech from Mr Stevens that Australians should take a glass half full approach to the economic outlook, designed to douse expectations of more monetary stimulus.  More recently, Mr Stevens has questioned the efficacy of monetary policy at low interest rates (to the best of my knowledge, without supporting theory or evidence).

Readers of this blog would be aware that Evidente has long held the view that the Australian economy has been mired in an income recession for some time.  Nominal GDP has expanded at an annualised rate of around 4% for four consecutive years, and the calendar year outcome for 2015 was the worst growth posted since the recession of the early 1990s.  It is little wonder then that nominal wages are growing at their slowest rate on record.

The RBA had acknowledged in its interest rate statement from April that the renewed appreciation of the Australian dollar could complicate the necessary re-balancing of growth.  But it was the strong disinflationary forces evident in the March quarter CPI print that would have tilted the central bank's view on the outlook for the economy and interest rates.  Underlying inflation now running at only 1.5% higher than a year ago - a record low - points to a shortfall in aggregate demand and a likely slowdown in labour market conditions.  No doubt, the CPI print would have given Mr Stevens - whose term as Governor expires in September - pause for thought about his legacy.  Had he left policy unchanged, would he be remembered as the central bank Governor who did nothing while core inflation fell 50 basis points below the bottom end of its target?

Strong population growth in Australia in the past five years - certainly stronger than most advanced economies - has helped to keep disinflationary forces at bay until now.  The RBA has therefore now joined the not so exclusive club of advanced economy central banks that are struggling to meet their inflation targets.  Yet, even with the overdue monetary stimulus delivered, Australia's OCR of 1.75% remains well above other advanced economies (see chart).  A comparison of Australia and the United States might put things in perspective.  Australia's annual core inflation rate is now lower than in the US, while the unemployment rate of 5.8% has been higher than the US for a while now.  But the OCR is 150 basis points above the federal funds rate!  Little wonder that the Australian dollar has remained resilient in the face of commodity headwinds for some time now.

Evidente has long argued that the OCR has been too high and that the RBA has under-estimated the power of monetary policy.  Evidente does not buy into the argument that the potency of monetary policy is diminished as interest rates approach zero.  Surely the widespread use of unconventional monetary policies such as large scale asset purchases, negative interest rates and forward guidance in recent years confirms that central banks are no longer constrained by the zero lower bound. 

This is not to deny that a range of structural reforms are necessary to boost real productivity growth over the medium term, but there is little political consensus to deliver these reforms.  It was too ambitious to expect an election year Budget to deliver a vision of economic reform.  There are modest tax cuts offered to middle income earners and small business, and a scaling back of superannuation tax concessions for high income earners. 

But from a macroeconomic perspective, the Budget is a sideshow to the RBA's rate cut.  The economy is suffering from deficient demand and more monetary stimulus is necessary to revive animal spirits in the corporate sector.  A policy rate of 1.75% is still too high given monetary developments across the advanced economies and Australia's disinflation.  As long as the RBA and APRA are satisfied that lending standards for housing remain prudent, Evidente expects the central bank to deliver another rate cut this year, most likely in August.