Still no clear direction for economy: RBA should hold

Economic data is once again painting a motley picture of the Australian economy. Slight improvements in the labour market, stronger commodity prices, and a headline inflation rate near the centre of the official target band opposes weakening consumer sentiment and a deterioration of the international economy. Appreciable risks exist on both the upside and the downside.

The CAMA RBA Shadow Board on balance prefers to hold firm but still considers it necessary that the cash rate is lifted in six-12 months. In particular, the Shadow Board recommends with confidence that the cash rate be held at its current level of 2.25%; the Board attaches a 67% probability to this being the appropriate policy setting. The confidence attached to a required rate cut equals 13%, while the confidence in a required rate hike stands at 20%.

Australian Bureau of Statistics figures shows Australia’s jobless rate fell slightly to 6.1% in March, accompanied by a marginal increase in employment and the participation rate. Wage growth remains muted.

The Australian dollar rebounded from its recent low and now fetches close to 80 US cents. Yields on Australian 10-year government bonds have also rebounded from a recent low to 2.59%. Both these developments suggest markets are cautiously optimistic about Australia’s near economic future.

Sydney’s housing market and domestic asset prices remain buoyant.

International conditions are deteriorating somewhat. European growth remains soft. A Greek default in the near future is a real possibility, along with a concomitant shock to the European financial system. China is looking to curtail the adverse consequences of excessive private debt.

Recent statistics from the US are showing a weaker than expected first quarter of economic activity. Consequently, the Federal Reserve Bank may delay increasing its cash rate. On the plus side, international commodity prices have rebounded slightly, benefiting Australia’s mining companies.

Confidence measures continue to be mixed. Consumer confidence slipped further, with the Westpac Consumer Sentiment Index coming in at 96.2 this month (99.47 in the previous month). Capacity utilisation is virtually unchanged. Coming off a recent high, the services PMI dropped slightly, from 51.70 in February to 50.2 in March. Business confidence, as reported by the National Australia Bank, increased from its temporary low of 0 to 3.

What the Shadow Board believes

The Shadow Board’s confidence that the cash rate should remain at its current level of 2.25% is up three percentage points, to 67%. The confidence that a rate cut is appropriate has fallen from 16% in April to 13%; the Shadow Board considers it more likely (20%, up from 19% in April) that a rate increase, to 2.5% or higher, is the appropriate policy decision for this month.

The probabilities at longer horizons are as follows: 6 months out, the estimated probability that the cash rate should remain at 2.25% equals 29% (down from 31% in April). The estimated need for an interest rate increase lies at 55% (up from 53%), while the need for a rate decrease is estimated at 16% (unchanged).

A year out, the Shadow Board members’ confidence in a required cash rate increase equals 65% (up two percentage points), in a required cash rate decrease 16% (unchanged) and in a required hold of the cash rate 19% (down five percentage points).

Comments from Shadow Reserve bank members

Paul Bloxham, Professor of Economics at Australian National University:

“A key question is over-inflating asset markets.”

Underlying inflation is steady and, at around 2.4%, it is still comfortably in the target band, albeit in the lower half. This suggests that demand has held up relative to supply in the economy, although growth is probably still a bit below trend. At the same time, a number of indicators of domestic economic conditions have lifted in the past month, including retail sales and employment, suggesting that the domestic momentum may be picking up, rather than slowing. Local asset prices have also remained buoyant and Sydney housing price growth still appears excessive.

The Australian dollar has appreciated over the past month, but this partly reflects rising commodity prices. On balance, the economic information that has arrived over the past month has been more positive for Australia. There also remains a key question about whether further easing of monetary policy could over-inflate asset prices, particularly given the continued exuberance in parts of the housing market. I recommend the cash rate is left on hold at 2.25% this month.

Mark Crosby, Associate Professor, Melbourne Business School:

“There is strong case for raising rates at the 12 month horizon.”

With the markets anticipating delays in increased official rates in the US it would seem wise for the RBA also to stay lower for longer, with raises in the rates risking appreciation of the dollar and further weakening the economy. At the 12 month horizon there still seems to be a strong case for raising rates closer to neutral.

Warwick McKibbin, Professor, RSE, ANU, CAMA:

“The RBA faces a difficult choice.”

Cutting interest rates will likely further inject a bubble into asset markets which will lead to high economic costs when the policy unravels. Ultra low interest rates are not a substitute for dealing with the structural adjustment that the Australian economy needs to undertake.

The longer that economic reform is postponed through political stalemate the more difficult the job of monetary policy will become. The ultimate questions for the RBA are: what is the objective of the current policy and what will be the most likely ultimate outcome of continually lowering interest rates in the current economic environment?

Is the goal to drive the economic adjustment to the commodity price decline or is it to buy time by artificially stimulating asset values in the economy to sustain demand until the politicians that are blocking needed economic reform realize the folly of their actions? It may be possible for the RBA to drive the adjustment but it is more likely that it can only postpone a structural slowdown.

Creating a significant mis-allocation of capital in an economy that will ultimately need major structural adjustment, while perhaps attractive in the short term, will likely create a proliferation of problems that will converge at some point in the not too distant future. My view is the RBA should hold its ground and focus attention on highlighting the fundamental economic problems that other policies need to address.

Perhaps with luck, ultra-low interest rates might bridge the policy vacuum created by parliament. But the more likely outcome is that cutting interest rates further without other policy support, will ultimately create another painful economic adjustment that Australia did not need to have.

James Morley, Professor of Economics and Associate Dean (Research) at UNSW Australia Business School:

“The RBA should not lower the policy rate to drive down the dollar.”

Despite the recent fall in headline inflation to 1.3%, underlying inflation remains within the target range at 2.3%. Meanwhile, the latest unemployment rate is 6.1%, which is down from its recent peak at 6.4%.

These conditions suggest that the RBA should hold the policy rate steady at the very low level of 2.25%, with concerns about an overstimulated housing market implying a tightening bias going forward.

The recent partial recovery of the Australian dollar largely reflects better external conditions for the export sector. Therefore, the RBA should not lower the policy rate to drive the dollar down.

Jeffrey Sheen, Professor and Head of Department of Economics, Macquarie University, Editor, The Economic Record, CAMA:

“RBA has the scope to cut the cash rate.”

I am marginally in favour of a cut in the cash rate because of the relatively weak outlook. My focus this month is on the following:

• Commodity prices remain depressed, and this problem will not change soon.
• The Commonwealth budget in May is likely to feature consolidation proposals.
• The US economy has temporary slowed its growth in the winter quarter, and the Federal Reserve is unlikely to raise its funds rate until at least later this year.
• The increasing risk of failure of the negotiations on Greek sovereign debt is a threat to financial market stability in Europe and beyond.
• CPI inflation in Australia for the March quarter is (temporarily) very low at 1.3% largely due to falling fuel costs.
• Wages, vacancy and employment growth remain modest in Australia.
• House price inflation may be a risk (mainly in Sydney), but this is investor-led and thus likely to encourage construction activity.

Overall, I think the RBA has the scope to cut the cash rate this month, and possibly again later in the year. If next year’s circumstances warrant it, normalisation of the cash rate can then begin from a lower base.

The CAMA RBA Shadow Board is a project by the Centre for Applied Macroeconomic Analysis, based at the ANU, which asks industry and academic economists what interest rate the Reserve Bank of Australia should set. Timo Henckel is the non-voting chair of the Board.

See all the Board’s April deliberations here.

Timo Henckel receives funding from the Centre for International Finance and Regulation (CIFR).