Macquarie's Brian Redican published a very thoughtful piece today. Here is an excerpt:
In 2006, initial data showed that the economy grew by just 0.3% in the June and September quarters, with annual growth around 2%. Despite that, the RBA hiked interest rates in May, August and November of 2006. Despite insipid growth, the RBA remained confident that the economy was healthy because employment was strong, growing by around 3%YoY while unemployment was around 5%.
Indeed, this paradox of weak GDP growth but strong employment was a major focus for the RBA in 2006. The October 2006 Board meeting minutes state:
"The news on the domestic economy in the past month had centred on the release of the national accounts for the June quarter. This had been a puzzling set of figures, particularly when set against recent indicators of strength such as labour market conditions." They went on…"The contrast between GDP and employment trends had persisted for the past 2½ years. Employment had increased at an above-trend pace since the end of 2003 but during that period GDP growth had been lower than the average for the current expansion. Other data on the labour market, eg for vacancies, were consistent with the strength in employment, so while some element of overstatement was possible in employment growth or hours worked, it was not likely to be significant. The implied slowdown in productivity growth appeared implausible."
The minutes also noted that, "growth in nominal GDP had been very rapid, owing in part to the rising terms of trade, and this had supported buoyant growth in government revenues. However, it was acknowledged that the measurement errors involved in converting nominal to real magnitudes in measuring GDP growth could be greater than usual at present, given the large changes in relative prices taking place."
Now this sounds very familiar: weak GDP growth, strong employment and surging terms of trade. And to cap it off we would note that the when the RBA hiked rates in November 2006, the standard variable mortgage rate increased from 7.8% to 8.05%. The standard variable mortgage rate is currently 7.8%. As Yogi Berra once said, "It's déjà vu all over again."
So what does this mean?
To summarise the points we've argued so far:
1. 2006 proved that weak GDP growth is not necessarily an impediment to rate hikes.
2. The RBA believes that employment is a more reliable guide to domestic strength than GDP, and employment has been very strong.
3. The RBA is unlikely to alter its long-term forecasts, where GDP growth accelerates to 4% and inflation accelerates to 3%, because of its confidence in the mining boom.
4. In 2006, the standard variable mortgage rate increased to 8.05% before the RBA kept rates steady for 9 months. As inflation rose to 5% in 2008, it seems likely that the RBA considered this one of those episodes where they have "looked back and thought we should have tightened a bit earlier."
If this is an accurate description of the RBA's thinking, then the risk of a rate hike in the next 6 months still seems very high. Indeed, as long as commodity prices remain strong and mining investment plans remain in place, then the RBA could go at any time. And a rogue high CPI print in Q4 (perhaps due to higher food prices because of recent flooding) could be the trigger.
In contrast, the hurdle for rates to remain on hold for the next year seems very high. Basically, we would need to see the flow of data continue to undershoot the RBA's targets. That is, growth must remain significantly below trend and inflation must be at the low end of the RBA's target band. The other factor that could undermine the case for further tightening is a sustained rise in the unemployment rate, although that would only follow a period of sub-trend growth with a lag. And while the RBA Governor did seem pretty relaxed in that testimony, it should be remembered that unless he was thinking about hiking rates in December, there was no reason to provoke his political inquisitors with threats of further rate hikes.
Unfortunately, we will not find out whether the RBA has shifted its economic forecasts until after the February Board meeting, when the next Statement on Monetary Policy is released. And if the Q4 CPI does blip up in late January, then the RBA might have already pulled the rate-hike trigger at its February Board meeting. In this light, the upcoming speech by RBA Assistant Governor Phil Lowe entitled "Forecasting in an Uncertain World" on Wednesday night might be much more interesting than its title would suggest.
