I missed the mark with regard to Gov Stevens’ speech yesterday, at least as far as the market was concerned. For, while much of what he said in his speech has come out of the RBA in other communications – or was calculable given what they had told us – the market reacted as if it was new-news, and cash rate expectations declined.
Thus, on the only score-board that matters, i was wrong that he would not sound 80% sure. Following the speech, the market was left pricing in ~90% chance of a cut in August – up from ~80% prior to the speech.
Some point the finger at his repeat of the scope to ease line from the statement and minutes:
We have been saying recently that the inflation outlook may afford some scope to ease policy further if needed to support demand. The recent inflation data do not appear to have shifted that assessment.
This was surely a line that the market reacted to – however we knew the inflation result was around their forecasts, so for me this was not the entire story.
That story was really a lower-for-longer story, where slow consumption growth took centre stage.
Gov Stevens recycled two charts from a speech two years ago (updated, of course). The first shows the slowdown in both income growth and consumption growth – along with the increase in the saving rate.
The implications for rates are familiar for those who have trained – more supply of investible savings lowers the market clearing price, which means the equilibrium cash rate has declined. Of course, in some models slower consumption growth also means lower equilibrium rates.
For the question of why, Stevens again gave the answer ‘House prices’. The emerging bank view appears to be that the credit boom boosted house prices and that they will hold around this level in real terms, perhaps declining slowly for a time first of all. If that is the case leveraged housing investment isn’t a great alternative to saving, and folks will therefore desire to save more from their income. I agree, and think that this is what we are seeing.
So long as income growth is weak (which is what the falling terms of trade will do) and house price gains do not drive sizeable gains in wealth (and hence rapid consumption growth) it seems likely that the equilibrium rate will remain well below what we’ve been accustomed to in the past (even after accounting for spread widening).
The old neutral was a real cash rate of around 3%. My best guess is that spreads are worth 100bps, and that these structural factors are worth another 100bps, which means that the neutral real cash rate is around 100bps, or maybe a little higher.
With cash headed for 2.5% and inflation around 2% just now, we will be about 50bps stimulatory – which fits pretty well with the fact that a few of the interest rate sensitive indicators (such as auction clearance rates and house prices) recently picked up, when cash got to 2.75%
It is pretty normal to get about 100bps below neutral in an easing cycle, which matches pretty closely with my guesstimate that the terminal cash rate will be 2% (though clearly the bank is in no rush to get there).