Why the RBA refuses to cut rates

Fri, 08 Sep 2017  |  

This article first appeared on the Yahoo7 Finance website at this link: https://au.finance.yahoo.com/news/1714473-004126949.html 

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Why the RBA refuses to cut rates

The forecasting record of the Reserve Bank of Australia is poor, but that has not stopped it relying on its forecasts, rather than hard data, when setting monetary policy.

In the past year where interest rates have been left unchanged at a level that is amongst the highest in the industrialised world, the RBA has been banking on its forecasts for stronger economic growth, a lift in wages and rising inflation to validate its failure to join the rest of the world with ultra low interest rates.

There are a couple of consequences of this approach from the RBA.

Importantly, despite its status, the RBA is made up or mortals. Sometimes its forecasts are wrong. And in recent years, the RBA forecasting record has been wide of the mark on growth, wages and inflation.

As the data has unfolded through the course of the past year or so, contrary to the rosy outlook from the RBA, economic sluggishness remains the order of the day.

Annual GDP growth is just 1.8 per cent, one of the weakest growth rates recorded in the last 25 years and now one of the weakest in the industrialised world. At the same time, wages growth has never been lower, at just 1.9 per cent. The level of labour underutilization – that is the sum of the unemployment rate and the underemployment rate – is over 14 per cent, a level usually seen when the economy is near recession.

Inflation, which after all is the main target of the RBA, is in underlying terms running at 1.8 per cent, and has been below the bottom of the RBA target range for almost two years. In the current global environment of low inflation, it is difficult to see Australia’s inflation rate moving much higher over the near term and has close to zero chance of exceeding 3 per cent, the top end of the RBA target range.

At the same time, Australia’s high interest rates relative to the rest of the world are a magnet for capital inflows to the point where the Australian dollar has rocketed back to 80 US cents. If sustained, this will act to dampen export income and will make it harder still for local firms to compete with importers.
In other words, an inappropriately high Australian dollar is working to slow an already soggy economy.

It is also quite clear that housing construction is cooling. This is not good news, not just for the next year or two of GDP, but it risks leaving Australia with a housing shortage if new construction lags population growth and other demographic changes. Lower interest rates would encourage new construction.

Everyone knows that changes in interest rates impact with a long and variable lag. That is, it takes something around 3 to 18 months for a change in monetary policy to impact on the economy. As such, forecasts are always going to be part of any policy deliberation.

But when the data confirm the forecasts of a year or two ago are consistently wrong and the errors are all in the same direction, remedial action – ie a policy catch up is needed.
In the mean time, the weak economic growth leaves around 725,000 people unemployed, and around 1.1 million underemployed. Had the RBA been a little more reactive to the data and less taken with its rosy forecasts and it had cut interest rates further to boost the economy, the number of people suffering for the lack of work would be materially lower.

And worryingly, the latest noises from the RBA suggest it is still upbeat about the outlook and has no inclination, at all, to cut interest rates.

This means that growth and jobs will be lower than need be for a while to come.

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Do we need to be worried about Australia's economic outlook?

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Do we need to be worried about Australia's economic outlook?

The Reserve Bank of Australia reckons that the next move in official interest rates is more likely to be up than down. RBA Governor has said so in recent weeks as he talks up the prospects for the economy over the next year or two.

This is disconcerting news for everyone out there with a mortgage or a small business loan, especially in a climate where the business sector is doing it tough and when wages growth is floundering near record lows. The good news is that the RBA is likely to be wrong and the next move in interest rates could be down, such is the run of recent news on the economy. Failing an interest rate cut, the hard economic facts suggest that any interest rate rises are a long way into the future and if they do come, there will not be all that many.

At this point, it is important to bring together the issues that would need to unfold to see the RBA pull the lever to hike interest rates.  At the simplest level, the start of an interest rate hiking cycle would need to see annual GDP growth above 3.25 per cent, the unemployment rate falling to 5 per cent and less, wages growth lifting towards 3 per cent and more and underlying inflation increasing to 2.5 per cent.

This is where the RBA expectation for higher interest rates is on very thin ice.