Financial markets expect a cut, but RBA Shadow Board says hold

Financial markets are pricing in a 75% chance of a rate cut when the RBA meets, which would be its second such move this year.

However, the CAMA RBA Shadow Board advises against this. The central dilemma for the RBA persists: spur growth with loose monetary policy and risk exaggerated asset prices that lead to a misallocation of capital and costly adjustment in the future, or hold the line on monetary policy and risk an imminent weakening of aggregate demand.

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 64% probability to this being the appropriate policy setting. The confidence attached to a required rate cut equals 16%, while the confidence in a required rate hike stands at 19%.

Australia’s jobless rate, according to the Australian Bureau of Statistics, edged down to 6.3% in February, due both to an increase in employment and a marginal decline in the participation rate. There are no signs that wage growth is wakening from its torpor, making it unlikely that consumer spending will pick up significantly.

The Aussie dollar continued to slide and now fetches about US75¢. As yields on Australian 10-year government bonds are now down to 2.35%, barely 40 basis points higher than for US Treasuries, global investors will search for yield elsewhere. A further decline of the Aussie dollar may well be on the cards.

Sydney’s inflated housing market remains cause for concern, as prices rose 3.3% month-on-month in March alone. The local stock market is also performing strongly, the ASX200 closing at 5900 just before Easter.

Global weakness and uncertainty keep battering the domestic economy. European growth remains soft while Germany is searching for solutions to the Greek debt crisis. Brazil is faltering and Russia, suffering from weak energy prices and political scandals, is experiencing a dramatic slowdown. China will aim for an annual growth rate of 7%, in line with previous announcements, while the US economy continues to expand modestly. The Federal Reserve Bank’s rhetoric points to a measured increase in the cash rate in the near future.

Confidence measures continue to be mixed. Consumer confidence slipped marginally, with the Westpac Consumer Sentiment Index coming in at 99.47 this month (100.7 in the previous month). Capacity utilisation edged up from 79.94% in January to 80.42% the following month.

The manufacturing PMI increased to 46.29 in March from 45.51 in February, while the services PMI advanced significantly, from 49.50 index points in January to 51.70 index points in February, the highest in more than a year. At the same time business confidence, as reported by the National Australia Bank, decreased to 0, the lowest in more than a year.

What the CAMA Shadow Board believes

The Shadow Board’s confidence that the cash rate should remain at its current level of 2.25% is unchanged at 64%. There is far less confidence (16%, up from 14% in March) that another rate cut is appropriate whereas the Shadow Board considers it more likely (19%, down from 22% in March) 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: six months out, the estimated probability that the cash rate should remain at 2.25% equals 31% (unchanged from March). The estimated need for an interest rate increase lies at 53% (down from 56%), while the need for a rate decrease is estimated at 16% (up from 13%). A year out, the Shadow Board members’ confidence in a required cash rate increase equals 63% (down one percentage point), in a required cash rate decrease 16% (up four percentage points) and in a required hold of the cash rate 24% (down two percentage points).

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Comments from Shadow Reserve bank members

Mark Crosby, Associate Professor, Melbourne Business School:

“Monetary policy in Australia is loose enough.”

Ongoing uncertainty in the global economy continues to dominate the outlook, with uncertainty around Greece and Europe, and China being the most important factors affecting monetary policy. The most likely outcome is that Greece will continue to muddle through, and China will find a way to achieve near 7% GDP growth in 2015, so that monetary policy in Australia is loose enough at present settings. Worsening in the global outlook should see further rate cuts, while ongoing stability should see the RBA looking to normalise rates early in 2016.

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 is what is the objective of the current policy and what 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 misallocation of capital in an economy that will ultimately also need significant 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 economic 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.

John Romalis, Professor of Economics at the University of Sydney:

“Potential costs down the line.”

Although economic activity and inflation are likely to remain subdued in the near term, we have to wonder whether the short-term benefits of any additional monetary stimulus are sufficient to offset any potential costs down the line stemming from rapid increases in property rises in some markets.

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).