A funny thing happened yesterday. It was not the RBA dropping their easing bias — which was fairly obvious given the Q4’13 inflation surprise — but the way the market traded on the news.
To see why this was odd, we need to rewind so as to give context to market pricing before the statement was released.
The above charts (from the Q4 SOMP) summarise the situation following the November RBA meeting: their central forecast was for growth to remain below potential (which is thought to be about 3%yoy) until mid 2015. As a result of this weak growth outlook inflation was expected to be around or below the 2.5% target for the entire projection period (the tick up and down mostly reflected the pass-through of a lower exchange rate to prices).
Given a forecast for growth that is too slow, and the fact that inflation was expected to fall back below 2.5%y/y once the weaker currency was fully passed through, it was no surprise that the RBA had been telling the market that cuts were the most likely policy step over the visible horizon.
Reflecting this, they put the following into their minutes (in both November and December):
The Board’s judgement remained that, given the substantial degree of policy stimulus that had been imparted, it was prudent to hold the cash rate steady while continuing to gauge the effects of earlier reductions, but not to close off the possibility of reducing it further should that be appropriate to support sustainable growth in economic activity, consistent with the inflation target.
So at the conclusion of the December meeting, the RBA’s message to the market was cuts were more likely than hikes. This is not what was priced, however: the market had only a very small bias toward further cuts. A fair summary was that pricing suggested that cuts and hikes were about equally probable.
By the time we hit the yesterday morning, that’s surely what was priced: the Dec’14 bill implied a 3m rate of around 2.7%, which is basically consistent with the RBA being steady at 2.5% (the current 3m fix is around 2.6%). Reflecting this, I had figured the market was pretty much priced for the RBA dropping their easing bias (meaning that pricing suggested cuts and hikes were as likely as each other – which is pretty much what ‘neutral’ means) and that we’d not see much of a move when the RBA made the change of bias explicit in their statement.
Well … i was very wrong about that! The Dec 14 bill has sold off 11bps since the announcement (above chart) and the AUD rallied sharply (below chart), to be up by about 2c against the USD.
To my mind, this is exactly what the RBA wanted to avoid. It is in this context that I think we should place their experiment with ‘forward guidance’ in the post meeting statement.
On present indications, the most prudent course is likely to be a period of stability in interest rates.
My view is that the RBA knew (from experience) that losing their easing bias might cause the market to price in rate hikes, and they wanted to avoid this inappropriate increase in yields (and consequent appreciation of the AUD). Forward guidance was their attempt to prevent this from occurring.
If you take this perspective, it neatly frames the ‘if sustained’ comment about the weaker AUD — the implication being that the RBA’s easing bias might re-appear if the market gets it wrong and pushes up the AUD.
Clearly the price action tells us that their first experiment with forward guidance failed — but i expect that the RBA will continue to elucidate the case against rate hikes in coming days and weeks. We still have the same domestic issues (terms of trade decline / mining investment drop, and the need to tighten fiscal policy to close a structural deficit of about 3% of GDP) and there’s the new EM downside risk to add into the mix.
Given this backdrop, it’s hard to see how the labour market might get tight enough to create a core inflation problem — which is what’s required to get rate hikes.
Contrary to popular press, we don’t have an inflation problem at the moment — we have some FX pass-through and price hikes in semi-administered ‘non-tradable’ goods. Folks cannot substitute away from these goods in the short run, and wages growth is very weak, so this sort of inflation is likely to work like a tax hike and sap spending power.
Domestic headwinds continue to blow hard, and offshore headwinds are rising (if our trading partners get weaker currencies and higher rates it will be bad for our exports), so (partly because the market got their ‘forward guidance wrong’) it’s most likely that the RBA’s next step will be to re-instate their easing bias.
Any tightening bias seems at least a year away.