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Friday, August 5, 2011

The RBA’s in crisis

Let’s lay the cards on the table.

Australia’s central bank, the RBA, is in a state of crisis.

After a surge in underlying inflation, the RBA’s executive team tried to push for at least one rate hike this year—in May, it is believed—and were rolled by their dovish Board.

Market chatter claims that the Deputy Governor, Ric Battellino, privately believes this was a mistake.

Bond traders no longer place much faith in what the RBA communicates, since it seems unwilling to act with any consistency or back up its language with credible decisions, as I will show below.

Hence we had the bizarre situation where the Board’s statement following this week’s meeting declared that members had formally considered hiking rates, and remained ‘concerned’ about inflation, which resulted in the markets immediately pricing in three full rate cuts.

We know that despite a 20% appreciation in the currency, which is being aggressively reversed as I write, and tepid economic growth, Australia has experienced an underlying inflation rate that is a full 100 basis points above the RBA’s 2.5% per annum target over the last half year.

This comes after bad inflation misses in 2007-08 with core inflation now averaging 3.3% per annum since Glenn Stevens was appointed in September 2006.

We know that there has always been a trade-off between inflation, growth and employment, and if central banks want to credibly reduce the former, it normally comes at the cost of the latter in the short-run.

Yet after 20 years of uninterrupted economic growth, Australians seem especially unwilling to pay for price stability. They seem to have forgotten what life was like in the 1970s and 1980s with high inflation and high rates.

If lifting rates today from near all-time historically low-levels (in inflation-adjusted terms) with a 4.9% unemployment rate, 3.9% wages growth, and 8% disposable household income growth is going to be hard, how on earth will the RBA raise them if high inflation persists in far less favourable economic conditions?

The RBA is terrified that a decade of low productivity combined with labour market re-regulation and an ageing population have reduced Australia’s ‘potential’ or non-inflationary growth rate (and increased the non-inflationary unemployment rate).

A final problem for the RBA is the composition of its Board, which has been empowered under the kinder and gentler Glenn Stevens. Former Board Members have gone on the record to highlight the differences in Board management under the MacFarlane and Stevens’ regimes. While Stevens has undeniably superior corporate governance skills, he is bequeathing a lot of decision-making power to six non-expert and highly conflicted business executives who run major retailers and exporters like Woolworths, Origin Energy, BlueScope, PrimeAg, WalMart and so on.

Today the RBA’s Board is said to comprise of six doves, two hawks (the Governor and Deputy Governor), and one unknown in the form of the Treasury Secretary, who historically is presumed to represent the Government’s interests.

Contrary to what some commentators have suggested, the RBA Board is no longer a submissive beast that does the executive’s bidding. The executive has been unable to get its preferred policy outcomes endorsed, with some of the external Board members said to be in favour of cutting rates.

This situation has been exacerbated by the recent departure of the only two external hawks, Donald McGauchie and Warwick McKibbin.

The disconnects between what the RBA executive are saying in speeches and publications like the Statement on Monetary Policy (due this morning), and the policy decisions being implemented by the Board, are starting to cause financial market mayhem.

Following the RBA's decision this week to hold rates, and the explicit revelations that the Board was "concerned" about inflation and had considered raising rates, bond prices immediately surged and implied interest rates plummeted.

On that day, the entire "yield curve", which shows the interest rates offered at different maturities between zero and ten years, "inverted". This means that all other interest rates had fallen below the RBA short-term 4.75% cash rate.

Specifically, the implied interest rate on 3 year Australian government bonds fell to below 4.0% while the 10 year government rate declined below the cash rate for the first time since 2008.

The Aussie dollar, which normally moves up or down in lock-step with interest rate expectations, has been smashed, and as I write is trading a full 5.5 cents below its 1.10 US cent peak just before the RBA's Board meeting. (A falling currency will be highly inflationary if it persists.)

The RBA was apparently shocked by the financial market's response. Privately, they told journalists they had inserted the language noting the Board had contemplated hikes precisely because they wanted to avoid the markets assuming cuts.

The markets’ very aggressive dismissal of the RBA's words given, once again, the absence of credible actions poses another problem for the central bank.

At 10.30am today it is scheduled to release its inflation projections for the next three years. For some time now it has used "market pricing" for interest rates as the technical parameter underpinning these forecasts.

In the first quarter of this year, markets were pricing in two hikes, which is what the RBA assumed.

Now markets are pricing in up to three rate cuts, the RBA could be forced to reveal core inflation projections at unprecedented levels. While it is possible they retain this approach as a slap-in-the-face to their Board, I expect a more conservative tactic.

I am guessing the RBA is going to simply assume that rates remain unchanged from their current levels given it can no longer input market expectations that are so divorced from what the RBA would have investors believe.

The RBA is fond of telling people that it likes to 'smooth' expectations by avoiding surprises and so forth. This was one rationale for tipping off journalists about the direction of interest rate movements before its Board had the opportunity to meet (a practice that seems to have mostly stopped).

Yet the evidence suggests that this RBA has a communications problem. It shocked financial markets last year by raising rates in November (this ended up being a double hike care of the banks) following an extremely low third quarter core inflation reading.

I had expected them to hike the month prior, which had the advantage of preceding a potentially low inflation result (as proved to be the case).

We found out subsequently that the reason the RBA waited the extra month was because three key external Board members were, unusually, absent from the October meeting. (This was, in fact, an explanation I posited at the time.)

Following a shockingly high first quarter inflation number, the RBA went into hawkish overdrive, predicting for the first time ever above-target core inflation in 2013.

Having previously thought the RBA would be on hold for an extended period of time, the interest rate markets had conniptions and started ramping up the probabilities of hikes.

One of the RBA’s main explanations for not moving immediately was that they needed time to ‘bring the community along with them’.

I argued forcefully otherwise, suggesting that they should hike in May while noting that (a) I did not think they would have the fortitude to pull it off and (b) a hike in June would be crucially reliant upon positive data flows (a dependency the RBA had created by stating rate changes would be influenced by future information).

This was a mistake, I claimed, since it made them (ironically) beholden to the “high frequency” data flows the Governor has said are mostly noise.

Prior to Tuesday’s Board meeting, the interest rate markets were pricing in a slim, 15% probability of a hike. I myself thought there was a high probability they would go at one of the next two meetings, although August initially posed problems in the context of the US debt ceiling crisis.

Yet once this was resolved, August seemed like it was very much live (ie, a greater than a 50% probability), although I did outline four reasons why the Board might get the yips again.

Ex ante, the RBA Board likely drew comfort from the fact that a decision to leave rates unchanged would satisfy the markets’ expectations. Instead, they got one of the biggest one-day moves in interest rate history.

Indeed, the inversion of the yield curve will start delivering de facto rate cuts to fixed-rate borrowers should the banks pass these changes on.

If the RBA wants to improve its credibility, it needs to act with vigilant consistency. It has one objective: keeping inflation within its 2-3% per annum target range on average over the cycle irrespective of the short-term consequences for employment or growth. Long-term price stability will beget long-term prosperity.

Australian inflation looks to be rising and becoming more volatile. Our potential growth rate may be lower after a decade of sub-par productivity and labour market re-regulation.

If the RBA is worried about its political independence at this very early point in the economic cycle, god only knows how they will respond when faced with much more difficult decisions down the road.

The striking inconsistency here is that Glenn Stevens had no qualms breaking precedent by raising rates in the middle of the November 2007 election, which saw the Coalition lose government.

Yet when it comes to making tough decisions on unequivocally burgeoning inflation pressures, the financial markets believe he has lost his nerve.