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Thursday, October 27, 2011

RBA's decision on Tuesday will be historic in shaping our understanding of Bank

[This is today's column for Property Observer and Business Spectator.]

After the 0.30% core inflation result yesterday (technically, the average of the perfectly consistent “weighted median” and “trimmed mean” prints), which was presumed to have followed decelerating core inflation over the first (0.85%) and second (0.60%) quarters this year, a rate cut next Tuesday should be a done deal.

Most of the RBA’s song-birds have evidently been told so. An increasingly emboldened Peter Martin, from Fairfax, who previously broke the news about the hugely significant downward revision to the ultra-high second quarter inflation results, confidently describes a cut next week as “more than a certainty”.

Another would-be RBA proxy, News Limited’s Terry McCrann, who on his day can be a market-mover and was once known simply as the “Shadow Governor” because of his uncanny ability to predict RBA decisions, declared, “We are now headed for a Cup Day official interest rate cut and the banks will pass it on in full and quickly to borrowers. Both these predictions are at Black Caviar odds and just as certain.”

Finally, we have those persistently prescient financial markets (not!), which have put 100% probabilities on rate cuts on several occasions over the last 12 months and are yet again telling us that November is in the bag. In fact, after the CPI yesterday, the probability of a rate cut rose to more than 100% because the market was saying that there was a chance the RBA could go by more than the standard 25 basis points.

Along these lines, former economic advisor to Julia Gillard, Stephen Koukoulas, who boldly forecast a rate cut in October, which was never likely given the RBA was always going to wait for the CPI, has been even braver this time around, projecting not one, but two rate cuts next week.

On the basis of the information above, any reasonable person would conclude that an easing next week looks like a “sure-thing”. But I suspect the situation is a tad more tricky than this. In the minutes after the CPI I thought a cut was government-guaranteed. But when Bloomberg published the historical revisions (see below), my probabilities attenuated somewhat.

On reflection, I would put the odds of the RBA reducing its target cash rate next week at around 70%. This contrasts with the 100% certainty claimed by Peter Martin, Terry McCrann, Stephen Koukoulas, and the markets. So while a cut is very likely, there are superficially credible reasons why the RBA should, in theory, continue to exercise the option to wait. Let’s walk through them.

First, after three attempts at estimating the RBA’s two preferred “core” inflation measures for the second quarter, it turns out that all the hoopla generated by economists, the RBA, and journalists about a major “turn-around” in Australia’s inflation rate, which involved a rapid deceleration in underlying inflation from 0.9% in the first quarter to 0.6% in the second quarter, was, according to the ABS’s latest numbers, wrong.

Recall that the first estimate of core inflation in the second quarter was 0.9%. After the similar 0.9% result over January through March (subsequently revised to 0.8%), this appeared to make the case for a hike in August a certainty. The view that the pace of inflation was slowly rising in line with the RBA’s projections was reinforced by revisions to the December quarter numbers, which have now increased from an initial estimate of 0.4% to 0.5% and, as of yesterday, to 0.6%. Starting in June last year, the quarterly rate of inflation prior to yesterday’s numbers looks like: 0.45%; 0.55% (revised to 0.50%); 0.40% (revised to 0.60%); 0.85% (revised to 0.80%); and 0.90% (revised to 0.80%).

Combined with worryingly low labour productivity, a very robust current and expected global inflation pulse driven out of both developing countries and politically inspired zero interest rate policies and money printing in North America, the UK and Europe, and the fact that we have private investment equivalent to 12% of GDP projected to take place in 2011-12 alone, you can understand why the RBA has assumed that Australia will likely have a major inflation challenge in the years ahead.

The crucial point to acknowledge here is that yesterday’s 0.3% core inflation print did emphatically not reinforce a decelerating inflation trend, as media commentators and the RBA had previously thought. This is because the ABS remarkably revised, for a second time, the important second quarter numbers back up to an unacceptably high 0.8%. This came after the ABS had revised down the initial print of 0.9% to just 0.6%, which was what triggered the recently dovish rhetoric.

The repeated revisions cast doubt on the reliability of Australia’s inflation data generally. And make no mistake, they are surprising: you would think that with three full months over which to measure price changes (cf. the house price data that is calculated monthly), and reportedly more than 100,000 price inputs, the ABS could furnish us with some dependable insights. Instead, we are getting quite radically different conclusions ranging from we have a major inflation problem, to inflation pressures are dissipating, to we seem to have problems again, at least over the first half of 2011.

If there had been no further revisions to the second quarter numbers, one would find unconditional unanimity in relation to a rate cut next week. The devil of the detail, however, has thrown a small spanner in the works.

This pickle is highlighted in the chart below. It illustrates that the third quarter numbers, which will be presumably subject to revision like their predecessors, are very much the odd-man-out. And the thesis that there is risk, albeit lower probability risk, that the RBA remains on hold, has been lent additional weight by Alan Mitchell’s column in the AFR today. In contrast to his media peers, Mitchell argues that there is no guarantee of a cut. And Mitchell is credible: he has been covering the RBA for decades and has yet to be sensationally wrong-footed by them, an observation that does not apply to his more confident colleagues.

Given the substantial changes to the ABS’s core inflation measures in recent times, any objective decision-making process would exercise considerable care in assessing yesterday’s results. Indeed, the RBA would note that the third quarter “ex volatiles” inflation number was a high 0.8%, and has averaged 0.7% per quarter (or 2.8% annualised) over the first 9 months of 2011. “Non-tradeable” (ie, domestic) goods and services inflation printed even higher at 1.2% in the quarter, and has averaged 1.1% over 2011. Sure these data are not seasonally-adjusted, and the non-tradeables will have been affected by the floods. But, at some point, the supply-shock that was the floods was meant to be reserved-out. And seasonal-adjustments simply smooth out intra-period data: over the duration of an entire year, the seasonally-adjusted and raw data should converge.

The second reason for pause is that the RBA has ostensibly established its own “decision-rule”, claiming in the October Board Minutes that it would only ease interest rates “to provide some support to demand, should that prove necessary.”

Well, we know that Q2 real GDP printed at a stonking 1.2% with private demand growing at a 5% plus annualized pace over the first six months of 2011. We also know, interestingly, that there have been consistent upward revisions to Q4 GDP, which is now estimated to have risen by a trend-like 0.8% even having suffered, in the RBA and Treasury’s opinion, a loss of about 0.5 percentage points from the effects of the east coast floods. That is, the final quarter of last year would have printed at a very high 1.1% or 1.2% had the floods not occurred.

And then we know that the recent activity data have been solid. Using the broader GDP survey, real consumption grew healthily in the second quarter. According to Westpac’s leading indicator index, economic growth is projected to be well-above trend over the next 6-9 months. Unemployment has remained low at around 5%. The monthly retail spending data has ticked up recently, and expanded at a 7% annualized pace over the last two months. And there has already been a de facto easing of interest rates via substantial reductions in fixed-rate home loans to as low as 6.3% today, modest tapering in the price of variable rate loans, and a softening of the currency from its 2011 highs.

A third observation is that if the RBA did not hike after initial core inflation results of 0.9% in Q1 and 0.9% in Q2, which after three recalculations, have stayed at 0.8% a piece (thus annualizing core inflation at a well-above-target 3.2% over the first half of the year), why would a forward-looking, inflation-targeting central bank cut rates on the back of one anomalously low core number in Q3?

As others have argued, 25 basis points here or there is not going to make a world of difference to the RBA’s inflation outlook. And there are nontrivial reputational risks for the RBA if its cuts in November only to confront a high fourth quarter core inflation outcome in January (perhaps followed by an upward revision to the Q3 numbers). What does it do then? Say “Oops, we got it wrong (again), and want to be back at “mildly restrictive”.” What is the RBA’s much-mooted “policy of least regret” as an avowedly inflation-targeting central bank? (And I have refrained from discussing the RBA’s inflation forecasts too much here simply because the RBA itself knows they have limited explanatory power.)

One case for cutting next week is that the RBA has clearly created expectations amongst journalists, and thus the community, that it would do so on the back of a low result. As I have noted too many times to count, this practice of pre-judging Board meetings and wording-up journalists is hazardous for both the Bank and the individuals in question. Terry McCrann, in particular, has now been humiliated by the RBA on two occasions in the last 12 months.

Today McCrann claims in his column that any suggestion there was “disunity” on the RBA Board over monetary policy is a “myth”. This is plainly incorrect. It has been clearly reported that at least one external Board member voted for hikes in the first half of 2011, only to be rolled by the wider Board.

It has been further speculated that other Board members have, at various times this year, argued for cuts. We know from the RBA’s Board Minutes after the first quarter inflation results that the Board felt there were arguments for and against raising rates, which was inferred to mean a lively “debate”. And we know that the Board explicitly considered doing so as recently as its August meeting. Finally, we know that after a decade serving on the Board, Warwick McKibbin has, following his resignation, been critical of the make-up of the Board, highlighting the risk of conflicts from intrinsically dovish private sector representatives, and recommending that its composition be changed.

McKibbin has also intimated towards political conflicts given the presence of the Treasury Secretary on the Board, a criticism that was reinforced by Freedom of Information releases showing that senior Treasury officials strongly disagreed with the RBA’s monetary policy decisions in 2008, and damagingly described the Bank as “schizophrenic” in discussions with important partners, such as the US Government.

Questions swirling around the RBA’s political independence were also reaffirmed when the Treasurer, Wayne Swan, broke with decades of convention, and controversially took-away the pay-setting powers of the RBA’s independent Board members on the basis that he felt they were paying senior RBA staff too much. In an attempt to persuade Swan not to make this change, the longest-serving member of the RBA Board, Jillian Broadbent, wrote to him and warned, “The Board believes that the current remuneration framework for the Bank is crucial to the Bank's continuing capacity to carry out its duties to the standards required, and would see any move to unwind it as undermining the capacity of the Bank to do so." Swan ignored her.

If the RBA cuts next week, we will learn a great deal more about the way this institution works. A cut will be a political exercise in building community goodwill in the event the RBA does have to raise rates to fight a more serious inflation problem down the track. A cut will confirm that the RBA finds it much more difficult to hike rates than reduce them. A cut will imply that the RBA is worried about its political independence, and treads especially carefully in the formulation of restrictive policy. A cut will tell us that the RBA does not have a Bundesbank-style policymaking bias towards keeping inflation low, but rather contextualizes policy decisions against the risks to its recently-won independence in a world in which most of its central banking peers are losing a grip on theirs.