Reserve Bank governor Glenn Stevens and his fellow board members sit down this morning to discuss monetary policy. As they do so, the world economy is slowing, Australia’s terms of trade are falling sharply, the Australian dollar remains persistently over-valued and the forward indicators for the labour market are pointing to a stalling in job creation and rising unemployment in the months ahead.
At the same time, inflation is hovering around the bottom of the target band, fiscal policy is about to see a further round of tightening and housing credit growth is floundering at a pace not seen since at least the mid-1970s. The solid growth in retail sales during the June quarter was clearly the result of the carbon compensation payments and we now know that retail spending registered a sharp fall in July. Consumer sentiment remains fragile, business conditions are soft, company profits are falling and house prices are flat.
These are the simple facts.
In these circumstances, it would be sensible to think that the Reserve Bank should be continuing its monetary policy easing cycle with another interest rate cut today. Instead it seems that the RBA board will leave interest rates steady, at least for today.
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Recent chatter from Stevens and the analysis in the recent statement of monetary policy and other speeches gives few hints of an imminent cut. The reasons for this hawkish approach from the bank is that its glass-half-full assessment of the economy hones in on the ongoing mining boom, the fact that monetary policy has already seen interest rates move to a little below the long-run average and an expectation that the slowdown in China is about to end.
The Reserve Bank seems unduly optimistic. In fact it is very difficult to find any domestic economic indicator other than mining capital expenditure that is strong.
An interest rate cut now would pose little risk to the inflation outlook. It is also hard to construct a case where a tick lower in rates would fuel an unhealthily strong lift in demand for credit when credit growth is so weak and still falling.
A rate cut would help take some wind out of the sails of the Australian dollar. In the past month or so, the debate over the dollar has become a little too cute. Some say the market is the best determinant of the Australian dollar and as a result the Reserve Bank should not do anything to influence its value. Others suggest that the overvaluation will correct unaided. Others aren’t all that sure that the dollar is in fact overvalued.
These are all half truths and those discounting the overvaluation story are clearly disengaged from what is happening in the economy. To be sure, no one knows for sure what fair value is for the Australian dollar today, or tomorrow or the day after. Is fair value 95 cents … 90 cents … 85 cents? It doesn’t really matter what the answer is when it is clear the dollar is not moving in line with its usual drivers.
You don’t have to know the air temperature is 39.6 degrees to know it is hot.
Stand outside in those conditions are you will sweat.
You don’t have to know that fair value for the dollar is 90 cents to know at current levels, it is hurting the economy. This morning’s level of about 102.50 cents is too high simply because the terms of trade are sharply lower and the global outlook is deteriorating. The trade exposed parts of the economy risk being hollowed out if the dollar stays misaligned for much longer.
It is important to highlight the call for lower interest rates in no way suggests the economy is performing poorly. It is more a call for the Reserve Bank to be forward looking, pre-emptive and flexible when assessing the growth and inflation risks likely to confront the economy over the year ahead and to respond to the evidence of most of the important indicators.
In the past, when discussing monetary policy pressures, Stevens has spoken of a policy approach of “least regret”. That means what policy setting is the one the RBA would look back on in a year and have the least regret making. For today, this boils down to delivering a modest interest rate cut and perhaps regretting that that move leads to an inflation breakout (highly unlikely) or alternatively holding rates steady and then seeing the economy falter as global conditions and the high dollar crimp activity and inflation (somewhat likely).
The bottom line of all this is that the Reserve Bank should be cutting interest rates today. It will be disappointing if the RBA does not move, but all will not be lost. It can always follow up in the next few months with a rerun of the May/June experience, which saw it “catch up” with 75 basis points of easing in two months.
Either way, it looks like the cash rate will be cut to a record low something near 2.5% in 2013. It is just a question how quickly and what path the RBA takes to get there.
*This article was first published at Business Spectator