Stephen Kirchner
Hope over experience
The minutes of the RBA’s February Board meeting revealed that the RBA contemplated what we said should have been done in December – a 50 basis point tightening. The Board minutes also made the same observation that we have been making in recent weeks: ‘the level of the cash rate in real terms arguably was noticeably below what might be expected given the economy’s circumstances. On this basis, a significant further rise in the cash rate could be necessary’ (emphasis added).
Why the RBA didn’t say this in the announcement accompanying the February tightening at the beginning of the month is one of those mysteries of RBA communication about which we can only shake our heads in dismay.
While the yield curve and the real effective exchange rate suggest that monetary conditions are tight by historical standards, the real cash rate remains too low. It is quite possible that Australia’s equilibrium real cash rate has shifted upwards due to the terms of trade driven growth in real national income. The RBA’s lack of traction over domestic demand from the increases in the official cash rate seen to date is certainly more consistent with monetary conditions being too easy than too tight.
In the end, the Board settled on a 25 basis point tightening at its February meeting, on the grounds that there had been a significant tightening in credit conditions and that ‘much of the effect of it was still to be seen.’ While this is certainly true, waiting for the full effects of recent tightening to flow through to the rest of the economy would take the better part of two years. It has been precisely this wait and see approach that has left the RBA well behind the curve on inflation control. The fact that increases in official interest rates this cycle have for the most part been implemented at the Board meeting immediately following the quarterly CPI release suggests that the Bank has been backward-looking and reactive in its approach to policy.
The interbank futures strip is now all-but fully pricing a March tightening, with follow-up tightening all but fully priced by May, a view with which we concur in the wake of the January labour force release. For its part, however, the Bank remains surprisingly sanguine on the growth and inflation outlook, despite presiding over a serious and sustained inflation target breach. RBA Assistant Governor Malcolm Edey’s speech this week was notable for the emphasis it placed on an expected moderation in demand and inflation:
"The RBA indicated in its latest statement that domestic demand would have to moderate if inflation is to be brought back to a satisfactory rate over time. The statement recognises that there are a number of forces at work that should contribute to that. As I discussed earlier, prospects for global growth have weakened, and this will have an impact on the domestic economy. Tighter financial conditions are another factor. We’ve already seen some easing off in credit growth to the household sector, and this is part of the mechanism by which tighter financial conditions can be expected to restrain demand over time."
This sounds like a triumph of hope over experience. The RBA’s implied forecast for fourth quarter GDP, to be released the day after the March board meeting, is implausibly low, although the upside ‘surprise’ on Q4 GDP should help validate the expected March tightening. The starting point for 2008 growth is thus likely to exceed the RBA’s February Statement on Monetary Policy assumptions.
Some of the other forecasting assumptions underpinning the February Statement are also being challenged. The 65 per cent increase in iron ore prices agreed by Japanese and Korean steelmakers with Brazilian iron ore producers this week are well above the 40-50 per cent increases the RBA has been assuming in its forecasts and it is likely that Australian producers will hold-out for even bigger price gains. The resumption of growth in the terms of trade in the second quarter this year after a two-to-three quarter pause will help sustain growth in incomes.
This week saw a political debate on Australia’s non-accelerating inflation rate of unemployment (NAIRU). The NAIRU is best seen not as a trip wire that is triggered at a specific rate, but as a range in which a declining unemployment rate is associated with an accelerating inflation rate. Since the underlying inflation rate has been accelerating steadily since the end of 2005 – after a year in which the unemployment rate was stuck at 5.1 per cent – we can safely conclude the NAIRU resides in the region south of 5.0 per cent. Turning points in the official cash rate cycle closely match turning points in the unemployment rate, but it is likely we will need to see an unemployment rate north of 5 per cent before the RBA contemplates a new easing cycle.
Next week, fourth quarter real private new capital expenditure is expected to rise 1.6 per cent quarter-on-quarter, highlighting continued strength in investment spending, with the market looking for an even bigger 3.1 per cent quarter-on-quarter gain. The strength in investment is a mixed bag for the inflation and interest rate outlook, contributing to short-term demand pressures, but also holding out the promise that the continued addition to the capital stock will eventually ease supply-side constraints on the Australian economy.
Also on the calendar next week is January private sector credit growth. We expect a 1.2 per cent month-on-month gain, with annual growth remaining at its strongest since the late 1980s. The RBA will interpret these data as implying that credit conditions are not yet overly restrictive. The strong growth in business lending partly reflects the re-intermediation of bank lending at the expense of capital markets. However, the Australian banking system has the capital base to support this growth and is likely to take advantage of the problems in capital markets to re-build margins.
Stephen Kirchner is an independent financial market economist. His blog can be found at http://www.institutional-economics.com.