The author has been described by News Ltd as an "iconoclast", "Svengali", a pollie's "economist muse", and "pungently accurate". Fairfax says he is a "Renaissance man" and "one of Australia’s most respected analysts." Stephen Koukoulas concludes that he is "85% right", and "would make a great Opposition leader." Terry McCrann claims the author thinks "‘nuance’ is a trendy village in the south of France", but can be "scintillating" when he thinks "clearly". The ACTU reckons he’s "an enigma wrapped in a Bloomberg terminal, wrapped in some apparently well-honed abs."

Wednesday, August 4, 2010

Which way for the RBA?

When thinking about the future course of interest rates, it is useful to keep a few things in mind. First, the RBA targets inflation ‘through-the-cycle’—and really not much else. If it takes a recession to get long-term price growth under control, the RBA will reluctantly enforce that outcome.

Second, the RBA has a formally agreed inflation target of two to three per cent per annum that the (previous) Governor first struck with the Treasurer in 1996. The RBA’s mandate is to keep price growth within this band over the medium term. It pays to remember that its success in doing so is only a relatively recent innovation, which was won in large part as a result of 1991 recession. The RBA was not a highly regarded central bank at the start of the last decade.

In the 1996 ‘statement’ signed with the Treasurer, the RBA formally subordinated its second legislated goal of maximising employment growth. Inside the RBA, there was a strongly held view that the ‘dual’ price stability and employment objectives created an unacceptable policy conflict. And this was reaffirmed in a recent research discussion paper released by the RBA, which showed that in Australia there remains a robust trade-off between inflation and unemployment. In fact, the RBA found that the age-old Phillips Curve was the single best predictor of changes in Australian inflation over time, as I explained in more detail here.

The problem today is that unemployment is sitting awkwardly at 5.1 per cent and the RBA’s analysis shows that once it prints with a ‘four-handle’ in front of it, inflationary pressures start to materialise.

The third, and contemporaneously most important thing to remember, is that on a purely empirical basis this RBA has failed to meet its price stability objective for three of the last four years. Until last week’s core inflation result, that is. But one quarter in 12 prints does not make for a satisfactory performance, as the RBA knows better than anyone.

I was surprised to stumble across this factoid when trawling through the inflation data some time ago. Having pointed it out, it has been picked up by others, including the RBA, which has now made much of the fact that it has wrested core inflation back inside its target range for the first time in three years.

One respected commentator remarked to me that he was taken aback that the RBA had ‘got away’ with this failing for so long with remarkably little media comment. I guess this simply reaffirms the critical lacuna that has existed around the central bank in days past as a result of most, if not all, commentators being reliant on the Bank for their informational fodder.

Threading all of the above together, I would summarise this particular RBA as being especially hawkish in its external projections. Given the choice, this RBA would, I suspect, much prefer to undershoot rather than overshoot its inflation target. And given the challenge, there is absolutely no doubt that this RBA would accept very low growth and rising unemployment if that is what it takes to keep inflation within the target range.

This background brings me to two opinion pieces today from arguably the single best predictors of RBA behaviour over time: Alan Mitchell of Fairfax and Terry McCrann of News Ltd. There is a striking and surprising conflict between the positions of these journalists, who the market regularly assumes have been ‘worded-up’ by the Bank.

On the one hand, we have the ‘Shadow Governor’, Terry McCrann, who tells us that there is no chance of a rate hike prior to November, and that the RBA possesses only a mild tightening bias. This is the consensus case. McCrann correctly argues that the world is an unusually uncertain place right now, and that the RBA probably has no firm vision of what the future direction of rates is. In this sense, the Bank will be data driven, which is true by definition.

In the other corner we find radically different rhetoric from Alan Mitchell. He has come out with a surprising, and left-of-centre article canvassing the possibility of a rate hike as early as September. Mitchell further contends that we are likely to get the best part of another 100 basis points worth of hikes in total. He writes confidently that there have been few changes to the RBA's May base-case projections regarding the trajectory for employment and inflation. His main thesis is that if RBA’s next Statement on Monetary Policy, which is released on Friday, reveals forecasts that are still anticipating inflation rising to the top of its target range, current interest rates, which are in line with average levels over the last one to two decades, will be too low.

The question is, Have either of these guys been worded up? For mine, Terry's line of reasoning is the easier one to make and much closer to the current consensus. The oddity here is Mitchell. Nobody is forecasting a rate hike in September, and yet he has speculated on it. Nobody is really confident about the future, yet he seems to be of the view that we are likely to face further tightening. Interestingly, another Bank confident, Michael Stutchbury, struck a similarly hawkish tone prior to the inflation print last week.

For what it is worth, the futures market is currently pricing just one more rate increase through to the end of 2011. And one is left wondering whether the current local bearishness is more an artefact of an unusual conjunction of circumstances, which will presumably generate a weak third quarter. These include the destabilising RSPT debate, the European sovereign debt crisis, the spectre of ensuing austerity measures, China’s need to put the brakes on its unsustainably strong growth, and, of course, the impact of a Federal Election, which is always a harbinger of heightened risk aversion. Time will be the judge.