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Friday, October 1, 2010

RBA expands its policy mandate, as I suggested

Today I am going to talk about two things you won’t read anywhere else. The first is an incredibly important change to the Reserve Bank of Australia’s (RBA) monetary policy mandate, which I predicted in these pages only last week. This has profound ramifications for all Australians. The second subject is the complex dynamics that will interplay to determine whether the RBA lifts rates next week.

It is worthwhile restating at length what I wrote here last week. I argued that “it would appear that the [Statement on the Conduct of Monetary Policy] that exists today does not accurately reflect the current conduct of monetary policy. In recent times, the RBA looks to have resolved to make arguably the single biggest change to monetary policy since the ‘inflation targeting’ framework was formalised in 1996.

Under the current statement, the RBA has one and only one medium-term goal: to keep consumer price inflation within a 2-3 per cent per annum band over the cycle…Following the cataclysm experienced during the GFC, the RBA has decided it wants to pursue a more ‘flexible’ inflation targeting regime that gives it latitude, on very, very rare occasions…to use interest rates to ‘lean-against’ asset price inflation...

There is a credible case that wild swings in asset prices that are propelled by leverage threaten the stability of the broader financial system, as we saw in the US and UK. One of the RBA’s regulatory responsibilities is to safeguard the stability of the banking system alongside APRA…Put more bluntly, there is a theoretical case for the RBA to tilt, at the margin, monetary policy to further enhance its financial stability aims…

Rather than seeking to expand the RBA’s monetary policy mandate in a subterranean fashion without the explicit endorsement of government, I would encourage the Governor to formulate and agree a new statement with the Treasurer. Modest changes could be made to the existing statement to provide the RBA with the flexibility it seeks…

This is entirely consistent with the RBA’s independent ‘financial stability’ brief. Possibly the single biggest benefit of this change will be the mere fact that participants believe the RBA is capable of using its interest rate stick to deal with these risks. The threat could be in and of itself sufficient to stifle the exuberance the RBA is targeting. But these changes have to be made with the active support of government. They must also be explicitly incorporated into the statement that articulates the scope of monetary policy.”

Yesterday the RBA announced that it had signed a new Statement with the Treasurer. And it was gratifying to see that the RBA had agreed the changes I proposed. In particular, the RBA inserted 337 new words affirming its responsibility for managing the economy’s financial stability. These included the following:

“The stability of the financial system is critical to a stable macroeconomic environment…Without compromising the price stability objective, the Reserve Bank seeks to use its powers where appropriate to promote the stability of the Australian financial system. It does this in several ways, including through its central position in the financial system and its role in managing and providing liquidity to the system…”

The most critical words are those bolded above. Effectively the RBA has now agreed with the Government that it can use whatever ‘powers’ it deems appropriate to ‘promote the stability of the Australian financial system.’ This means the RBA now has, for the first time, an explicitly-agreed mandate to use monetary policy to respond to innovations in asset price and credit growth that threaten the integrity of the banking system and the wider economy.

It is game over for the foreseeable future as far as the ‘leaning against the wind’ debate is concerned. There is evidence to suggest that the first genuine application of this new approach occurred in 2009-10 when the RBA started including references to asset prices in the ‘Considerations for Monetary Policy’ section of its Minutes. There is also a credible case that rates were raised more aggressively than the old inflation-targeting regime would have required in 2009-10 in order to minimise the risk of speculative and destabilising asset price inflation emerging.

Let us now turn to the question of when the RBA will next raise rates. The RBA’s job is to keep inflation within a target band of 2-3 per cent per annum. Many interpret that to mean the RBA has a long-term target of about 2.5 per cent. The Bank has generally come close to meeting this with headline CPI averaging 2.7 per cent since 1996 when the inflation target was first formally agreed.

Yet there appears to have been substantial upward drift in inflation since the middle of this decade. Under Glenn Stevens headline inflation has averaged a higher 3 per cent. More worrying is the fact that the RBA’s two other preferred measures, the so-called ‘trimmed mean’ and ‘weighted median’ benchmarks, have averaged between 3.4 and 3.5 per cent during Stevens’ term (see charts in post below). On pretty much any measure, the RBA has failed to achieve its price stability objective in recent times.

These are important considerations when thinking about future rate changes. If the RBA is targeting a through-the-cycle inflation rate of circa 2.5 per cent, it definitionally needs to start push inflation down well below this level to realise its goals. Yet headline inflation in the last quarter was 3.1 per cent while the two preferred measures printed at 2.7 per cent. That is to say, all measures of inflation look to be bottoming-out near the top of the RBA’s target range.

If the RBA’s most likely case of a once-in-a-century mining boom materialises, and unemployment continues to push down from its low 5.1 per cent level to the full-employment rate of around 4.75 per cent, inflation will start accelerating again in the absence of substantial rate increases.

There is, nevertheless, presently a schism amongst investors and economists as to whether the RBA will hike in October or November.

After weak building approval, house price, personal credit, and business credit data yesterday, which coincided awkwardly with strong employment data and solid housing credit growth, the futures market was pricing only a 50:50 probability that rates will rise next week.

Half the economists think the RBA should wait until we get the next inflation print at the end of October, which may provide them with the necessary ammunition to tighten in November. The 12 year RBA veteran, Paul Bloxham, falls into this camp.

The other half think that the RBA should go next week in advance of the third quarter CPI print precisely because it might be weak.

I look at the logic and can only arrive at one conclusion. The RBA is targeting through-the-cycle inflation. And the RBA tells us that they are changing the cash rate today to influence consumer prices up to two years away. It seems bizarre to then base today’s cash-rate deliberations on inflation outcomes over the prior three months rather than your forecasts for the future.

Many attribute the RBA’s failure to meet its price stability objectives over the last four years to this tendency to focus too much on current, as opposed to expected, inflation. More specifically, some low inflation prints in 2007 allegedly ‘head-faked’ the RBA into keeping rates on hold when it should have been tightening.

By delaying the decision until November the RBA is only reemphasising the importance of current data. If the third quarter inflation numbers then come out on the low side, it is going to be awfully difficult to justify to the market that you want to ignore them and still hike in November or December.

Another consideration is that a hike today only boosts lending rates by between 25 and 40 basis points, depending on what the banks do with their top-ups. Here the RBA’s Financial Stability Review, which was released yesterday, argued that the banks actually have no case to make top-ups. Net interest margins are at their highest levels since several years prior to the GFC while the banks’ return on equity and profitability are forecast to increase back to record levels.

Even assuming that the banks add on a full, say, 15 basis points, the headline mortgage rate will still only be 7.8 per cent. This is way below the 9.6 per cent peak reached in August 2008. Furthermore, the standard ‘discounted’ home loan rate will be a far lower 7.15 per cent. Since 1996, the headline mortgage rate has averaged 7.3 per cent. But discounted rates only emerged in the early 2000s, according to RBA data. This can hardly be described as super-tight policy.

We know that unemployment is falling towards the level beyond which wage pressures start re-asserting. And we know that the current government is unlikely to foster labour market flexibility. At 1.2 per cent, the last GDP print was well above the economy’s trend rate of growth. But GNI, which measures the total income realised by Australian residents, is rising much more rapidly than GDP, which implies that households will soon have the capacity to ramp up spending, should they be so disposed. After 160 basis points of rate increases since 2009, house price growth has flat-lined but housing credit growth is still increasing robustly at a rate above 7 per cent per annum.

The risk for the RBA is that if they delay their decision until November, and the CPI print is low for some reason, they will find it awfully difficult to rationalise moving again until the first quarter of 2010. This would give households an extra five months to build above-trend momentum alongside the resources sector. And throughout this time rates would have been sitting in a neutral position.

Another criticism of the go-October position is that the RBA will not want to have to ‘reverse-out’ a hike if there is some global calamity in the future. The argument here is that the RBA likes to smooth interest rates and is paranoid about making policy errors.

Yet based on its inflation record over the last four years, the RBA has made repeated policy errors by under-clubbing its CPI forecasts. A hike in October removes the risk of relying on the next inflation read and being potentially pushed to the sidelines until 2010.

If there is a future global catastrophe that forces the RBA to change course, history will presumably judge the RBA’s May hike a mistake too. Either way you look at it, the RBA is going to have to reverse out recent hikes.

The arguably more important point here is the question of the RBA’s inflation-fighting credibility. The evidence shows that since the mid 2000s the RBA has lost a grip on its 2-3 per cent through-the-cycle target. If this pattern persists, the RBA will do its central banking brand enormous damage.

As I have argued before, the RBA has an asymmetric response function: it should, all things being equal, prefer inflation to undershoot rather than overshoot its target. Delaying the decision until November once again runs the risk of the RBA getting behind the rate curve.