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Wednesday, December 8, 2010

The RBA's challenge

Glenn Stevens’ most likely successor, Dr Phil Lowe, is giving an important speech tonight, entitled, “Forecasting in an Uncertain World.” I was hoping that he would speak about something along these lines. Most of the obvious topics—China, India, the terms of trade boom, structural adjustment across the economy, etc—have been done to death.

In the past week I have spent a bit of time trying to get my head around the RBA’s communications in the context of their policymaking challenge. At first blush, I find the Bank’s recent rhetoric, which has lent weight to futures market expectations of only one rate hike in 2011 and none in the first half of the year, a little puzzling.

While I will explain the essential conflicts that give rise to this bewilderment in a second, let me first share with you some hypotheses as to what might be driving the RBA’s external statements assuming, for the time being, that they are, in fact, materially divorced from the expected rates trajectory.

If the RBA’s bullish ‘central case’ proves out, we can be pretty confident that it will require another circa four cash rate hikes, if you take Paul Bloxham’s base-case as a guide. (Bloxham left the RBA in September after 12 years with the Bank.)

There is every chance the RBA is concerned about the risks that this policy path will pose to the housing market. Rismark has been vocal in stating its view that if the RBA does indeed end up making another 3-4 hikes, we will likely see some modest nominal house price declines. In the goldilocks scenario, this is no bad thing, and will only improve valuations.

The concern, of course, is that we confront a negative feedback loop with investors punishing those banks with large residential mortgage exposures, which could in turn persuade lenders who are worried about their share price performance to ration housing credit (this arguably occurred during the GFC).

And that quickly pushes you towards a UK-style situation where notwithstanding the very solid underlying housing market fundamentals—ie, an intrinsic shortage of supply as documented by the Barker Reviews—the rationing of credit by banks was the catalyst that precipitated substantial house price falls, which then triggered higher default rates that further depressed prices, and so on.

It is a noteworthy aside that the causality that characterised the UK woes was the opposite of what happened in the US where rising default rates propagated price falls, which undermined collateral values and only then resulted in system-wide credit rationing.

Recall that the RBA’s second regulatory responsibility over and above keeping inflation in check is known as ‘financial system stability’. This basically means protecting banks with asset-liability mismatches, which is principally achieved via the RBA’s ‘lender of last resort’ liquidity facilities. This involves the RBA lending to banks when counterparties refuse to do so because of perceptions of solvency risk (the distinction between illiquidity and solvency is a fascinating subject that I will return to another day).

The RBA might be a tad anxious that despite its forecasts for robust household income and employment growth, there is still a (lower probability) risk that 9-10 per cent mortgage rates cause nontrivial nominal house price declines that threaten the collateral values underlying the circa $1.1 trillion worth of residential mortgages that sit on Australian bank balance-sheets.

In this way, the housing market could present an awkward constraint on monetary policy: that is, while the RBA would like to lift interest rates to a certain threshold to accomplish its price stability goals, it might be restricted in doing so because of the hazards this exposes Australia’s highly concentrated banking system to.

So one sneaky hypothesis I have is this. By reinforcing the market’s expectations that there will be less than one rate hike next year, which we can be reasonably confident runs contrary to the RBA’s central case, the central bank is subtly seeking to flatten the yield curve out to a horizon of around three years.

This has important economic consequence. Most significantly, it alleviates pressure on the pricing of all fixed rate loans. If, by way of contrast, the RBA was to ‘hawk-up’ and encourage the market to price in, say, a peak cash rate of 5.75 per cent, which is where the market had projected the cash rate would end up earlier this year, the increase in implied future interest rates would compel banks offering fixed-rate loans to businesses and households to raise the price of their products.

By assuaging these expectations, the RBA is implicitly helping risk-averse residential and business borrowers who have questions about their ability to service much higher (variable) interest rates to lock-in a more comfortable fixed cost of capital today.

As an alternative intellectual experiment, let’s assume that I am totally wrong, and all the market economists, who have almost universally shifted their next rate hike back to the second quarter of 2011, are right. Let’s suppose the RBA is saying exactly what it thinks.

To my mind, that raises the spectre of a serious policy conflict. On the one hand, the RBA has relentlessly informed us that Australia’s economy currently has very little spare capacity and is operating near its maximum potential growth rate.

As Brian Redican of Macquarie argued yesterday, one can ignore the weak third quarter real GDP print on the basis of the logic the RBA used in 2006 when it claimed that the employment numbers were a better guide to the economy’s real-time performance (this is also a view shared by HSBC’s Paul Bloxham). To quote Redican:

“In 2006, initial data showed that the economy grew by just 0.3% in the June and September quarters, with annual growth around 2%. Despite that, the RBA hiked interest rates in May, August and November of 2006. Despite insipid growth, the RBA remained confident that the economy was healthy because employment was strong…while unemployment was around 5%...The October 2006 Board meeting minutes state…"growth in nominal GDP had been very rapid, owing in part to the rising terms of trade…However, it was acknowledged that the measurement errors involved in converting nominal to real magnitudes in measuring GDP growth could be greater than usual at present, given the large changes in relative prices taking place."

Now this sounds very familiar: weak GDP growth, strong employment and surging terms of trade. And to cap it off we would note that the when the RBA hiked rates in November 2006, the standard variable mortgage rate increased from 7.8% to 8.05%. The standard variable mortgage rate is currently 7.8%. As Yogi Berra once said, "It's déjà vu all over again."”

So here is the issue. The RBA has told us that we are about to experience an unprecedented private investment boom. The bankable component of that, which is the work that has already begun, is going to boost GDP by about 10-15 per cent assuming that it does not get cancelled and runs to budget (there are upside risks if we have cost blow-outs).

Economists expect this investment boom to really kick-off in the second half of 2011. The RBA has also told us that the unemployment rate is very close to its ‘full employment’ level beyond which we get wage price pressures. And private sector wage growth has already started ticking up at a healthy rate.

Finally, we know that this RBA is very much scarred by the experience of 2006-07 when it got "behind the interest rate curve" and had to play catch-up in 2007-08. Glenn Stevens was unusually frank about these mistakes in his testimony to parliament a couple of weeks ago, ruefully observing, “I cannot think of very many cases in history where we looked back and thought, ‘Yep, we tightened too soon.’ I can think of several times where we looked back and thought we should have tightened a bit earlier.”

The clincher is this: if the current setting of rates is only a “little above” average, and the RBA is convinced that it is going to have to raise rates materially to liberate the spare capacity needed to accommodate the private investment boom, why would it wait until the second half of 2011 to do so? Or, as many economists claim, wait until it gets hard evidence of these capacity constraints emerging? Is this not yet another example of the “inertia” Glenn Stevens criticised in his parliamentary testimony? In his own words, the problem with the logic that “’Let’s just get a bit surer before we do anything’” is that, “once you are sure, you are late, almost certainly."”

A more internally consistent analysis is that the RBA continues to raise rates pre-emptively, even in the face of weakish real-time data, in order to ensure that the economy has significant slack well before this once-in-a-century investment boom.

Let's think about this a different way. Imagine you are the CEO of a company that is about to massively expand a small division (analogous to Australia’s resources sector). The investments you will make in this division will be equivalent to, say, 20 per cent of the company’s total annual revenues. The limitation is that you cannot hire externally to resource this high-growth area. You have to reallocate internally. So what do you do? Do you wait until your expansion has already begun and only then seek to transition staff? Or recognising that these movements, and the reskilling that will be required, take time, do you ensure that the resources are available before the boom starts to avoid capacity constraints? This is the nub of the RBA’s policymaking problem.

A final thought is this. As I discussed last week, Australia’s economic future is going to be a much more volatile one given the telescoping of our trade relationships away from the old world towards the higher risk economies of China, India and other Asia. This is something the RBA firmly believes in. It is the the rub that comes with being propitiously leveraged to the two largest urbanisation processes in human history. But an equally interesting question is what does this mean for monetary policy?

For mine, it means that monetary policy will be more forward-looking in the future, and more unpredictable. The RBA will have to take greater risks than it has in the past, and place more emphasis on its forecasts rather than contemporaneous data flows. And this means it will likely make more mistakes. That is not a bad thing. It is just an inevitable cost associated with the RBA doing its job.