RBA Lowe retains an easing bias

RBA Deputy Gov Lowe gave a speech today, entitled Developments in the Mining and Non-mining Economies.

As usual, it’s a good speech that contains lots of interesting facts (such as that the mining sector accounts for 15% to 20% of the economy, once you do the input-output table maths).

For markets the focus ought to be on the confirmation that the Bank retains an easing bias. This message is contained in the final paragraph of the section discussing the mining and non-mining economies:

The overall conclusion from this work is that given the huge pipeline of mining investment and the current relatively low unemployment rate, it is likely that conditions will continue to vary significantly across industries for some time to come. This work also serves as a reminder that improving productivity growth remains the key to strong output growth in the non-mining-related parts of the economy. It also suggests that there is some scope for non-mining-related demand to grow a little more quickly than has been the case in the recent past

The key bit is that there is scope for faster growth in the non-mining sector.

On this, Lowe noted that:

The biggest surprise was probably in terms of home building. We had expected dwelling approvals to pick up gradually over 2011, but this pick-up did not eventuate. One possible explanation for this is that it is one of the side effects of a return to more traditional savings and borrowing behaviour by households. This change in behaviour is having ripple effects through the economy, including through a lowering of expected capital gains on housing.

How do you get faster growth? Well one way is to ease monetary policy. The hold up has been the (interest rate sensitive) housing sector, so lower rates ought to do the trick!

But the cash rate is already pretty low, I hear you say … what gives?

This picks up on one of my favourite themes – that neutral is lower (and may still be declining). One of the reasons neutral is lower is due to a decline in the expected returns on borrowed money. Thus, the user cost of capital is rising.

It is my strong view that one must lower the estimate of neutral for two reasons:

1/ to account for the widening margin between the RBA’s target overnight cash rate and the rates firms and households pay (this takes neutral to ~4%); and

2/ for the decreased demand for borrowed funds, due to the lower expected returns on borrowed money.

The credit data and finance approvals data tell you that policy is not easy.

For those that are interested, I recommend Mishkin 2007, where there is a good summary of housing and the monetary transmission mechanism, with special emphasis on the user cost of capital.