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."

Tuesday, November 8, 2011

The RBA is officially in “wait-and-see” mode

The RBA is officially in “wait-and-see” mode after it first downward adjustment to its target cash rate back to a notionally neutral 4.5 per cent. In its 72 page Statement on Monetary Policy (SMP) released on Friday, the RBA cut all of its growth and inflation projections. I was asked by a friend before the SMP what I thought it would say. My response was:

“I expect all core [inflation] forecasts to be between 2.50 per cent and 2.75 per cent, with possibly a 3.0 per cent in 2013. The RBA is highly unlikely to give any direction in the SMP given it does not know itself what it will be doing with rates following the fourth quarter CPI release in late January. Thus, the SMP is likely to be vague/open-ended…I think RBA will be very eager to emphasise "neutrality" as the main policy objective.”

The RBA made all the anticipated downgrades, while signaling uncertainty about its longer-term expectations by offering a 2.5-3.0 per cent inflation range in 2013. So while the RBA “hopes” for on-target core inflation of 2.5 per cent per annum in 2011 and 2012, it believes the balance of risks are skewed to higher results in 2013. In addition, the RBA says these forecasts presuppose a rebound in Australia’s productivity performance in concert with wage restraint over the next three years. It would privately acknowledge that these could prove to be optimistic assumptions.

I’ve previously noted here that the RBA does not believe it can forecast inflation with any high degree of accuracy, and the SMP lends weight to that view. Despite a rising path of core inflation over the five consecutive quarters to June 2011, the RBA’s hawkishness has been cauterized by a triumvirate of: (1) the lowest underlying inflation outcome in September since way back 1997 (based on the “trimmed mean” measure); (2) marked changes to the way the ABS calculates its inflation numbers; and (3) conflicting revisions to the ABS’s past inflation data (eg, the second quarter going from +0.9 per cent to +0.6 per cent and then +0.8 per cent).

After accounting for the ABS’s new inflation smoothing and weighting methods, the RBA now thinks that year-on-year underlying inflation in Australia is around 2.25 per cent to 2.50 per cent, or slightly below the mid-point of its target, through-the-cycle objective of 2-3 per cent per annum.

Don't be fooled by the artificial precision here. Just as the RBA has in various research reports and speeches conceded that it cannot project future inflation outcomes to single decimal places, likewise it does not like being held to a “point estimate” target.

In the Governor’s words, the name of the RBA’s game is keeping core inflation to “two point something” as frequently as it can while acknowledging that there may be tax changes and other supply shocks, such as natural disasters, that temporarily knock it off course (eg, by lifting headline inflation).

To understand the RBA’s current state of mind, you need to wrap your head around the following dynamics.

First, if one simply looks at the underlying inflation numbers in year-on-year terms, one can conclude that prices are rising at a modest pace, in contrast to what the RBA had earlier thought.

As a contradictory aside, in Friday’s SMP the RBA observed that core inflation had risen at an above-average rate over the first half of 2011. This defuses claims made by some folks that Australia’s core inflation spike was limited to just the first three months of the year.

Nevertheless, by using the year-on-year numbers the RBA can maintain that underlying inflation is anodyne. On the potentially anomalous September print, the RBA does hedge its bets by noting that the “quarterly” data need to be interpreted with “care”. Once bitten, twice shy. For all the RBA knows the low third quarter result could be revised back up in late January, as both the December 2010 and June 2011 data were.

A second insight is that 2011 has undermined what remaining faith the RBA has in its own projections. Crucially, this means that is has no choice but to drop its 2010-11 experiment with genuine monetary policy “pre-emption”.

The theory goes that the RBA sets interest rates on the basis of its inflation forecasts for the next two years. So even when the current inflation pulse is weak, the RBA has every right to lift the price of money in order to keep future price pressures within its target band. On this basis, current inflation numbers are only relevant insofar as they affect the RBA’s projections.

This theory has unraveled for two reasons. First, the RBA has discovered that trying to make a case for higher interest rates amidst middling economic conditions is an awfully difficult practical exercise. There was a tremendous backlash in 2011 against the RBA’s hawkish sentiments, even with the confirmatory evidence of the high core inflation results over the first half of the year.

You can see this challenge manifest in the RBA’s actions. The RBA ended up ignoring the first and second quarter inflation data, which were in line with its hawkish expectations, but cut rates the second it got one low print.

I used to think the RBA had an intrinsic bias towards tighter policy or higher interest rates; that is, it would prefer to undershoot rather than overshoot its 2-3 per cent per annum target given its past performance. There is now a case to be made that the RBA’s policy bias runs the other way: ie, towards tolerating slightly higher inflation given its community constraints.

The other issue with pre-emption is that the RBA cannot set interest rates today based on its expectations of the future if those expectations are faulty (or subject to high uncertainty).

So we are now left with a simpler decision-making process. Once Australia’s cash rate is sitting at neutral, the RBA will be practically guided by what the data tells it is actually happening in the real economy.

Turning back to the RBA’s current headspace, a fourth observation from the SMP would be that the Bank unmistakably believes that the distribution of risks is tilted to the downside over the near-term.
While it has slowly come to this perspective, I suspect that Glenn Stevens’s recent trip overseas, much like Bill Evans’ 180 degree turn following a North Atlantic jaunt, has infused the Governor with a deeper appreciation of the challenges that confront the big developed economies. Recall that it was a similar trip to New York at the height of the GFC that compelled Wayne Swan to the view that Australia needed massive fiscal stimulus in order to protect it from the impending storm.

To summarise, the RBA knows that it has positioned the price of money at an innocuous place. Today you can get variable rate home loans for as little as 6.39 per cent. There are 1 year fixed-rate deals going at 5.89 per cent. Save a desire amongst some on the RBA’s Board to perhaps tweak the cash rate down one notch further, the Bank genuinely has no idea when, and in what direction, the next move will be.

This will depend on three things: what the January inflation data tells it about the pulse of consumer prices over the second half of 2011; what other tier-1 activity data, such as wages, GDP, unemployment and house prices, tell it about the speed at which the economy is advancing; and, finally, what is happening in North America and Europe.

One former RBA Board member, and an eminent global economist, Professor Adrian Pagan, has been critical of the RBA’s decision to “trim” rates by one-quarter of a percentage point. Specifically, Pagan argued:

I can’t see the reason why you would cut interest rates by 25 basis points – I don’t believe in 25 point cuts. I think that’s a silly situation we got into with making such small adjustments…And I don’t think the international situation is as bad as everyone thinks it is, but 25 basis points is not a response to that. If you really thought it was bad, you wouldn’t be doing 25, you’d be doing 50 or 75...”

While Pagan might be technically correct, I would make a couple of comments.

First, whether the RBA likes it or not, this will not, in practice, be a small adjustment to monetary policy. Almost everything in economics hinges on “expectations”: that is, what we plan on doing. The average Australian family expected at least 2-3 rate hikes over 2011-12, and a big chunk of the community—around 25-30 per cent—were budgeting on four hikes or more.

The RBA’s about-face is going to have a tremendous impact on these expectations, which will swing from hikes, to stable rates or cuts. That is, the expectational effect of the RBA’s decision is more like 2-3 rate cuts. This will be especially powerful in interest rate sensitive sectors of the economy, such as housing.

Second, it is, to be sure, easy to construct a case that the RBA did not need to shave rates by 25 basis points, especially when, in the RBA’s words on Friday, “underlying inflation…is expected to pick up a little towards the end of the forecast period, with a greater likelihood that it will be in the top half of the target range than in the bottom half.”

All else being equal, this opinion combined with the risks signaled in the RBA’s 2013 projections, imply that it has a slight tightening bias, if it is setting policy today on the basis of its forecasts of the future.
However, the RBA is being a more tactically nuanced than this. First it needs to manage the six independent business executives that sit on its Board, who are not instinctively disposed to embracing higher rates. Make no mistake: if and when inflation does eventually rear its foul face again, the RBA is going to have a huge task on its hands.

The doves will argue that the RBA got it wrong in 2011. (As a matter of pure fact, the RBA forecasts were arguably right in Q1 and Q2, but wrong in Q3.) Nonetheless, the optics here are that the RBA has had to undertake a policy reversal. Getting its wider Board to trust its decision-making will not be a fait a compli.

This is why I believe the RBA will need demonstrable historical evidence (ie, data) that inflation is on the rise again before it has the fortitude to lift rates. That may mean waiting for at least six months of data before tightening its monetary policy screws.

As a more general comment, long-term forecasting of rates and inflation is, as I argued forcefully here, a mug’s game. The world is too complex, with too many interdependencies, to have any chance of consistently getting the long-term estimates right. What analysts and investors should concentrate on is understanding, as best they can, the RBA’s decision-making framework, and how the Bank responds to new events.