I hate being wrong, and I was wrong in size today — missing the RBA’s 13th rate cut since 2002. This move took the RBA’s target for the overnight cash rate down 25bps to 2.75%; it is now -200bps since late 2011, when this easing cycle started, continuing the cycle of lower lows.
In general, we can divide rate moves into two kinds: demand moves and inflation moves. I think today was the second type — an inflation move. Inflation moves are less sharp than demand moves (as inflation is much smoother) so this probably means that the RBA is unlikely to ease further over the next few months (unless demand does begin to fall off a cliff).
For cuts, the most common type is the first type: central banks tend to ‘ease on demand’. In a typical case demand is lower than expected, which results in the CB’s inflation forecast being revised down and permits the central bank to cut their policy rate.
Ideally these would be the most common moves in both directions, as monetary policy works with a lag so policy makers must target their inflation forecast — and innovations in demand are the most important input to that process. In practice, however, it is more often the case that policy makers ease sharply when demand drops and tighten slowly as inflation rises.
Therefore the second kind of moves are less common in cutting cycles — it isn’t very often that a central bank cuts rates because historical inflation has been lower than expected. This may be something of a surprise: but because potential output evolves only slowly, policy makers are normally able to predict inflation reasonably well once they know prior demand.
However, all relationships change over time, and from time to time inflation will either be lower or higher than prior relationships suggested, and this will lead to changed estimates of the economy’s potential supply. We have had persistently low inflation for the last few years (excluding supply shocks) so there is scope to think again about Australia’s potential supply.
… which brings us to the May 2013 board meeting.
Looking through the statement, I do not see the demand downgrade that the RBA had previously suggested was required to get the Board to lower their policy rate. Indeed, the statement might easily have been attached to an ‘on hold’ decision.
The global economy assessment is basically unchanged. The mention of Japan’s easing measures is positive (as they are a significant trading partner); though the potential impact of their easing policies on the AUD might have the RBA’s attention.
The commodity price assessment was little changed:
Commodity prices have moderated a little in recent months though they remain high by historical standards.
Financial conditions, if anything, are easier:
Financial conditions internationally continue to be very accommodative, with risk spreads reduced, funding conditions for most financial institutions improved and borrowing costs for well-rated corporates and sovereigns exceptionally low.
The domestic growth assessment was barely downgraded (my emphasis):
Growth in Australia was close to trend in 2012 overall, but was a bit below trend in the second half of the year, and this appears to have continued into 2013. Employment has continued to grow but more slowly than the labour force, so that the rate of unemployment has increased a little, though it remains relatively low.
… and they sounded more confident about the firming in the non-resources sector …
There has been a strengthening in consumption and a modest firming in dwelling investment, and prospects are for some increase in business investment outside the resources sector over the next year. Exports of raw materials are increasing as increased capacity comes on stream. These developments, some of which have been assisted by the reductions in interest rates that began 18 months ago, will all be helpful in sustaining growth.
So why the cut if global growth is about where the RBA expected, and domestic growth is basically around where the RBA anticipated?
The answer seems to be on the supply side. Inflation was a bit lower than the RBA expected (again!), and this seems to have altered their judgement about how fast demand might be allowed to grow:
Recent data on prices confirm that inflation is consistent with the target and, if anything, a little lower than expected. The CPI rose by 2½ per cent over the past year, and measures of underlying inflation gave a broadly similar outcome.
This, plus the fact that low rates are not having a particularly large impact on FX or credit growth, seems to have meant that the RBA judged that there were few reasons not to cut.
The upshot of these two forces being that there was greater scope for easing than they had previously judged (due to larger potential supply) and little downside to lower rates (weak credit growth and higher FX meant that few sectors were at risk of over-stimulation).
Newly armed with that extra scope, the RBA Board decided to use some of it — possibly with the view that not using an easing bias when unemployment is rising and inflation is low would weaken their credibility.
To my mind, these are the two things i got wrong on 7 May 2013.
I had been too focused on the demand side of the economy — the RBA’s assessment of which does not appear to have changed by all that much — and not sufficiently focused on what the very low inflation prints told us about the supply side of the economy. I also didn’t consider the potential credibility cost of not using an easing bias when inflation is too low and unemployment is rising.
After all, in the long run all that monetary policy can do is set the price level, and right now inflation is too low. At times, financial stability concerns may restrain further easing, however this is not one of those times — house price growth is in the low single digits, so it is not a barrier to further easing.
With this in mind, the RBA decided to ease 25bps to 2.75%. I think they’ll be pleased they did so — i would have voted for a cut myself.
Great stuff. Assessment of local econ events in Oz don’t get much better than this blog.
So in the absence of weakening on the demand side, there will be no follow up cut? Recent interest rate sensitive data (building approvals, house prices, retail sales off the top of my head) makes me think momentum there is already waning. It’s only one month so can’t assume its a new trend, it will be interesting to see how that evolves
Part of the building stuff was apartment approvals … But yep i think they wait for more data to sharpen their output gap estimates. However, if they print 2% for core cpi in q4 on friday i will revise my view!
So what you are saying is that RBA is guessing that AU potential output is a little higher than previously expected (because of low inflation prints). Which means they are trying either stoke rgdp or inflation – they don’t care. Follow up thought: is the RBA therefore targeting NGDP?
Yes, that is what i am suggesting. But i am afraid it is just boring old cpi targeting. They think they need more rgdp to get 2.5% cpi.
I think you are right that it’s still inflation targeting. Actually, this should be similar to NGDP growth targeting for demand shocks. It’s only for supply shocks that they lead to different policy outcomes.
I wonder if you are over-complicating things a bit by distinguishing between demand and inflation. In reality, all the RBA can do is influence nominal demand – the split between real growth and inflation depends on the supply side. This is consistent with your point that they have decided the economy can generate more real output before generating higher inflation.
As to the up and down asymmetry point, I think this coloured by two things. First, the RBA hiked too slowly in 2006-7. Especially in late 06 and early 07 they could have hiked by 50 once or twice. Easy to say now I suppose. Second, they (correctly) cut radically in 2008 when hit by the biggest negative demand shock in 70 years. Under more normal conditions, more symmetrical actions could well make sense.
Finally, on the credibility point, I agree to an extent, but how is that issue resolved by their statement, which refers to using some of this scope (only)? Surely this just perpetuates the problem. If anything, this statement suggests further action more strongly than the purely conditional statement they had before.
Yeah, i am confused by the statement. If they print a 2% cpi forecast for dec qtr it’ll be clear it means a firm easing bias, but i am not sure we will get that. 2.25% will merely be ambiguous (as it’s mostly a base effect).
It could just be an ordinary turn of phrase – like i had 100 bucks and spent some of it down’t mean they will spend the rest next month.
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