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."

Saturday, May 14, 2011

Will the Reserve Bank of Australia do its job?

Enclosed below is the Bloomberg table of rate hike calls (click to enlarge). In short, the median economist thinks we will have a 5.0% cash rate by July, and another hike in November. Broadly consistent with Glenn Stevens's claim in parliamentary testimony earlier in the year that we would have a number of interspersed moves.

As an aside, while I love Stevens as a central bank governor (I reckon he is probably the best we have had in ages), I thought he was far too dovish in his late 2010 and early 2011 verbal communications. This is, after all, a central bank with a patchy inflation-fighting track-record with the same old problems unfolding again.

Now, I know what the RBAers are thinking. We need to bring the community along with us. We need to tell a story. We need to build the case for a move. BS. It is precisely this equivocality, the willingness to hesitate (May!?), that permits the community to second-guess the RBA's commitment to price stability, which in turn leads to volatile inflation expectations. It is this doubt that enables constituencies to argue that the RBA should "look through" inflation problems because of the costs of high rates (and the currency) on other parts of the economy, and because it purportedly has a dual inflation-employment mandate (wrong). If people are making a fuss now with a 4.85% unemployment rate, what will they be doing when the cash rate has to go 1.25% higher?

The RBA needs to be more like the ECB and Bundesbank. Take no prisoners, and crush the slightest sign of price pressure. You have tried pussy-footing around in the past, and it has not worked. Indeed, it has created confusion amongst those watching you most closely--ie, economists--who are increasingly arguing the RBA's communications have been inconsistent. A supposedly dovish Board Statement last Tuesday followed by an uber hawkish Statement on Monetary Policy on the Friday. Some economists are now positing that this reflects a disconnect between the RBA's Board and the executive. This is not a good look, guys.

While I have railed in the past about the RBA's executive using the media to manipulate Board outcomes immediately prior to meetings, I am absolutely in favour of the Bank harnessing key commentators to articulate its view of the world. This is a very powerful device (as proven in recent weeks), and a key weapon the Bank can use in managing inflation expectations. The rub is that they should avoid doing so during the days before a Board meeting.

Here there is another curious inconsistency: the RBA is willing to jawbone asset prices, like house prices, but it is less prepared to jawbone the one thing that it is meant to look after: inflation. Why? Because the RBA is worried that if it creates the impression there is an inflation problem, it will be come a self-fulfilling prophecy.

Sorry to break the news to you guys, but this logic is faulty. You need to create strong disincentives to wage-price spirals. Vested interests in the labour market need to know that they will be responsible for higher rates and higher unemployment if they make ambit wage claims. Doing the opposite would be like trying to be secretly tough on crime while presenting the image publicly that you are not worried about it. Australians have got used to core inflation running at 3% pa for the last 10 years. This is totally unacceptable, and you know it.

What is interesting about the Bloomberg table above is that ANZ, Westpac, RBS, Nomura, NAB, Merrills, Moody's, Deutsche and ICAP are all calling June based on the RBA's 'surprise' Statement on Monetary Policy (no surprise to readers here).

As discussed before, I think the RBA should have gone in May, and is a chance of going in June subject to the wages and vacancy rate data. (While I personally think they should go no matter what in June, what I want them to do and what they will do are entirely different things.) Even then, the RBA might see fit to wait another month given the optical problems of June (eg, a negative GDP number and the Budget). That would be a mistake in my mind. The Bank needs to get on with its job.

Yet unlike other central banks, the RBA has five dovish business executives to deal with on its Board, and might get cow-towed into acquiescing to their interests, and giving monetary policy sensitive sectors of the economy one more month of breathing room. A weak-willed call, this would be. And there is zero value in doffing your hat to the Budget. Like dovish statements on inflation, this creates perverse incentives. It was not tight enough. If you can hike in an election month (November 2007), you can certainly hike the month after the Budget.

Another interesting feature of the table above is that only one group, Moody's, is calling three rate hikes this year. Subject, crucially, to the data, I think this is a very real possibility. Assuming the RBA does not mess about, and does what it signalled it would do by hiking in June or July, if the Q2 CPI data is then as bad as Q1, they will almost certainly go again. That would be in August or, should the doves once again prevail, September. At that juncture, the question will then be whether they fire off a third hike before the end of the year. Again, the decision will be data driven: unemployment; wages; growth, etc. But I would not rule it out. Today I would put a 25-33% probability on three hikes in 2011, which would increase to 75% or more with a high core CPI number in Q2.

By the RBA's own analysis, even with two more hikes it has a helluva lot of work to do (ie, even with a 5.25% cash rate it has core inflation running above target in 2013). And guess what? I don't reckon they will be relying on the AUD come 2012. Quite the contrary, in fact. I would venture the AUD will emerge as a source of serious inflationary pressure as US yields rise. Look what happened overnight on the back of a surging USD. The AUD/USD pair slumped back to 1.057 cents.

Of course, if the Bank hikes in June or July, and Q2 inflation is low, it can claim some credit for the outcome. And, in a worst case scenario, if the Aussie economy blows up, it can slash rates from their high base, with an instant transmission mechanism care of the preponderance of variable rate debt.

Some economists argue that the RBA is desperately worried about making a policy error. While this is hard to conceive of assuming a 5.0% cash rate and given the data we have available to us today (full employment and high inflation), there is an important residual benefit associated with going one or two hikes too far: reputational credibility. You want the public thinking that you will not hesitate to do your job, and put inflationary pressures out of business when called into action. This, I guess, is a "lite" version of the inflation-fighting credibility the Bank unwittingly won during the 1991 recession when rates went far too high. We don't need a 17% mortgage rate again. We do need higher rates, however.