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Tuesday, October 12, 2010

Why the RBA didn't hike...

In a couple of weeks’ time the ABS (and APM) will likely report that Australian house prices have declined, or, best-case, flat-lined over the third quarter. Of course, this is old news: RP Data-Rismark have reported a modest tapering in seasonally-adjusted monthly dwelling values since the start of June. And this was no surprise given that Rismark had not projected any capital growth in the second half of 2010.

The biggest risk to our base-case view that the housing market will tread-water for some time is a sharp increase in the standard variable mortgage rate to nine per cent or beyond. As I have shown before, every time this has happened since 1993 it has put downward pressure on prices.

Now, we should not be worried about a bit of asset price deflation: it happens in all markets. It is just that Australia's $3.5 trillion housing market is so big, and house price indices measure changes in value across the entire nation, that deflation is a relatively rare event.

Yet, as I went to some lengths to explain here, the individual household does not own a nationally diversified portfolio of housing: they have one home, situated in one street, with all of its idiosyncratic risk. House prices decline all the time in individual suburbs. In 1991 there were quite substantial falls in asset values in, for example, parts of Melbourne and the more affluent suburbs of Sydney. We saw a similar pattern assert itself during the GFC when the million dollar plus market in Sydney and Melbourne declined by 10-20 per cent.

The key take-away here is that the probability of loss on an individual home is much higher than that which one would infer from a nationally diversified house price index (refer to this article for our analysis on the subject). Unfortunately, people all-too-regularly confuse the two.

It was, therefore, good news for the housing market when the RBA decided to keep rates on hold in October. Since just prior to the RBA’s October board meeting the market was pricing in a greater than 70 percent chance rates would rise, economists having been having conniptions over what prompted the RBA to make this surprising decision.

In this context, Macquarie Bank’s Brian Redican has offered up an impressive analysis of eight candidate explanations that could have convinced the RBA to stay its hand. These included:

1. The RBA never intended to raise rates in October (possible);
2. The complexion of the new minority government influenced the RBA (ie, regional push-back around a two speed economy necessitated a more compelling case to raise rates);
3. The RBA deliberately chose not to raise rates to "correct" the impression that it selectively briefs some journalists (mission accomplished given the passing of the former ‘Shadow Governor’);
4. The RBA just wanted to correct market pricing (big tick);
5. The RBA's internal liaison pointed to a substantial slowing in the economy (unlikely);
6. The RBA's forecasts have been pared back (unlikely);
7. Financial markets/global fears/threat of a second bout of quantitative easing—viz., money printing—(known as ‘QEII’) by the Fed stopped the RBA (possible); and
8. The RBA Board didn't accept the recommendation of the RBA staff (given credence by some journalists, but dismissed by others).

Brian concludes that overseas headwinds and the spectre of QEII are the most plausible possibilities, especially given remarks to that effect by an RBA board member, Graham Kraehe, after the meeting. He correctly notes, however, that such concerns will not be resolved when the RBA meets in November, since the Fed is scheduled to debate the next round of quantitative easing after the RBA’s board meeting. This leads Brian to suggest that a December hike may be more likely.

Overall, one gets the impression that economists are understandably scratching their heads confused by the RBA's recent decisioning. On the one hand, they are happy that they have a much more challenging job these days, and no longer need to rely on the likes of Terry McCrann and Alan Mitchell to divine the RBA’s intentions. There is a universal consensus that this a positive development. On the other hand, they now realise that this also makes life more complex.

To the RBA’s credit, it is seeking to facilitate the transition by ramping up its own communications regime. But there was always going to be this uncertain period as the RBA transferred the baton from its original media ‘voice-pieces’—ie, McCrann, Gittins, Mitchell and Stutchbury—back to its senior staff, where such responsibilities properly resides.

On the question of what happened in October, another alternative has been suggested to me: the RBA did not want to be held accountable for a total of two de facto rate hikes—one 0.25 per cent increase by itself and another, say, 0.20 per cent care of the banks—only to have its decision ‘judged’ a few weeks later by a very benign third quarter inflation read, which is what economists expect.

According to this school of thought, the RBA always planned on going in November or December after, rather than before, the Q3 inflation numbers had been released. The logic here is that the RBA buys into the argument most of us used in September that it cannot set rates on the basis of past inflation data, and ultimately has to be governed by its forecasts of the future.

But it would prefer to have the third quarter inflation numbers behind rather than ahead of it. This makes a great deal of political/tactical sense. The RBA would doubtless be pilloried in some quarters for hitting households with two rate hikes in an environment in which inflation was bubbling along within its target 2-3 per cent band.

It is much easier for the RBA to raise rates after the event on the basis of the view that inflation is ‘bottoming out’ at an uncomfortably high level. Even if the headline reading in the third quarter prints at a low, say, 0.6 per cent, year-on-year CPI will still be above the 2.5 per cent mid-point of its target range.

The other benefit of waiting until November or December is that the RBA can point to the tightening labour market, which its empirical research indicates is the best predictor of future inflation, and make the case that we are operating at full-employment with any further reductions in the unemployment rate likely to trigger price pressures.

One interesting curve-ball in all of this is the exchange rate. Continued appreciation of the currency will relieve the RBA of some of the burden of slowing down the economy. That would be good news for interest rate sensitive sectors, such as housing.