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."

Thursday, January 26, 2012

Australia's best economic forecaster thinks they hold, but will they really?

Ricardian Ambivalence, who, based on his track-record, looks to be the best market forecaster in Australia, has just put up a very good post on why he thinks the RBA will hold in February. His logic is impeccable: by the RBA's own analysis, economic conditions have improved since its last meeting in December (ie, the downside scenarios have not materialised); the RBA does not need to cut rates to boost the banks' net interest margins (based on only 1 basis point of NIM compression thus far); and the RBA cannot control the currency with policy.

But with the AUD/USD cross currently at US1.06 (some commentators called an AUD short at much lower levels!!), and many developed world central banks ditching their inflation targets and expanding their money printing programs, I think the market has reasonable grounds for pricing in a good probability of a cut in February. To be clear, I don't think it is the correct policy decision, but, just like in December, I think we are going to learn an enormous amount about the RBA's decision-making process, and how potentially basic and prone to public pressure that process may be.

Imagine if the AUD falls to sub-parity, and Q1 core inflation bounces even higher than Q4 (and we get more upward revisions to past data)? What does the RBA do then? Quickly start raising the cash rate again? While I think the decision should actually be very simple--exercising the option to wait has enormous logical appeal--I have a sneaking suspicion the RBA is going to make life very complex for itself.

Anywho, here is some of RA's thinking:

Last night’s EU PMI data (which suggests EU growth may have hit the nadir in Nov) and today’s Q4 AUD CPI numbers make a fairly good case for the RBA to hold their key policy rate at 4.25% at their 7 February 2012 Board meeting...

The global backdrop is better now than in Dec (US picking up, China isn’t hard-landing, EU growth pulse is quickening and credit crunch receding), the domestic growth data remains around trend, and abstracting from shocks, CPI looks to have been running at around 2.5%y/y for the best part of six quarters (H1 CPI was biased up, and H2 was biased down).

So, the RBA has the economy pretty much where they want it – and it’s also pretty much as they expected. The unemployment rate has been steady at ~5.25% for some time now, growth has been around trend (I think a touch sub-trend, but their assessment was ‘basically in line with trend’ at their Dec meeting), and it looks to me that asset prices are starting to stabilise / rise (equities up, houses look about flat).

Given these factors, the RBA will probably not downgrade their growth forecasts or lower their inflation forecasts in the Q1 SOMP (released on 10 Feb, following their 7 Feb Board meeting). With no downgrades, i cannot see how they can go from describing the Dec move as a close call (‘this did not suggest any strong need to cut interest rates’) to cutting in February...

Finally, there are three rate cut memes that i want to address:

1/ the RBA will cut to help the banks — the NIM loss from debt issued at recent wide spreads is ~1bps so far; the RBA has time to wait and see if funding margins stay permanently wide before they need to step in and protect major bank NIMs.

2/ the RBA will ease because of the AUD — the currency is too volatile a reason to act; doing so raises the risk that you’ll have to unwind the action (note, i’m explicitly leaving open that it’s a good reason to defer action). The AUD averaged 1.0619 (TWI 77.47) in Q2’11; 1.0492 (75.85 TWI) in Q3, 1.0118 (74.83 TWI) in Q4, and has averaged 1.0348 (76.84) in Jan’12. It’s in a range folks …

3/ The RBA will cut and say that they are now on hold — the RBA tends to try and avoid commitments about the future. So i think they’d sooner stay on hold at 4.25% and say that they are ready to ease if required than cut and say that they are on hold (this is another manifestation of the point i made w.r.t. the AUD, above … it’s easier to wait and see than to undo something).