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."

Wednesday, December 7, 2011

Don't expect the unexpected from this RBA

So David Bassanese from the AFR reminded me that he called the RBA's rate cut yesterday. I don't think anyone else in media land really picked it. The market was fully pricing it--had been since the last meeting. Stephen Koukoulas (aka "Koukie") was there three or four months ago--but he was also confident about them cutting 25 basis points in October and 50 basis points in November, at various times.

Bill Evans at Westpac, Brian Redican at Macquarie, and Tim Toohey at Goldman have been brilliant at anticipating this sharp turn-around in the RBA's monetary policy stance. One question is whether they picked it for the right reasons. If you were dovish because of the domestic economy, you were right for the wrong reasons. If you were dovish because of low inflation, well, I don't know what to say. We've had two high core inflation numbers in Q1 and Q2 (after multiple revisions) and one low result in Q3 (first estimate). Nobody is much good at forecasting inflation 1-2 quarters ahead. Almost all economists struggle to predict core inflation the day before the release. But if you were punting on low inflation as a driver of the RBA's 180 degree turn, you surely deserve some credit.

If, on the other hand, you were motivated by the offshore environment, and Europe and the US, in particular, well hats off to you. Bill Evans and probably Toohey fall into this category. Koukie I suspect too. Matty Johnson at UBS is another who fingered it early, and who was quick to call a European recession. He was confident about a December cut many weeks ago.

Bassanese's rationale derived from the "insurance" (or "put option") school of thought. That argument was an obvious one, but I was not convinced the RBA would necessarily acquiesce. I was 50:50 right up to the decision. Anyone claiming December was certain has probably got the last few months wrong. A good counterfactual is HSBC's Paul Bloxham. Blocker spent 11 years working under Stevens, Richards and Lowe in the RBA's economic analysis department. He only left there a year or so ago. Unfortunately, Paul has missed November and December. He's now switched his position and is calling a spate of cuts.

One of the smartest and most successful rate participants I know characterised it as a coin toss a day or two ago. There was a lot of money to be made going short interest rate futures if you had conviction about the RBA keeping its finger off the trigger. Right up to 230pm I was trying to clear a position in my head. I could not--I had this uneasy feeling, a little like I did right before the August decision to pause. One clear thought did come into my mind: whatever the RBA does today we will learn more about the way they think. And that really is the key take-away.

You here a lot of baloney from media commentators and economists who talk to the RBA and tell you--even to this day--that the RBA completely controls its own Board and is at-one with all its decisions. Anyone who says that is trotting out the house line. Of course the RBA wants everyone to think their relationship with the Board is always harmonious, and decision-making is always unanimous. But anyone who has sat on corporate boards knows that is not how they work.

We know that some RBA Board members wanted interest rates lower in the first half of 2011, and we know, again as a matter of absolute fact, that some were calling for higher rates. We obviously got neither.

What we saw yesterday, and what we have seen in 2011 is a classic committee-based decision-making framework. I know from years of personal experience that as soon as you run a decision-making process through a committee larger than two or three people, especially within a risk-averse or bureaucratic organisation, you get lowest-common-denominator solutions. You get 'easy' decisions that are straightforward to justify.

Super funds are a classic example: do what everybody else is doing. If everyone is over-invested in equities and underweight cash and fixed-income, do the same. Pick up the pieces after the event only when everyone else is doing the same. You can never be criticised if you are one man concealed by a crowd.

That's what we've witnessed this year. The RBA's Board comprises nine relatively ordinary individuals. We have learnt that they find it, unsurprisingly, very hard to make tough decisions. Everyone who has worked with the RBA will tell you that raising rates is hard work. We saw that in the first seven months of 2011. There were at least three months when a bolder, braver and more independent decision-making framework could have hiked. Would that have been a mistake? Of course not. If you hiked once earlier in the year (eg, in May or June when a tightening was on the table) you would be claiming credit for the low inflation print in Q3. You would have had much more justification for easing policy in November given the disturbing developments offshore and the supposedly altered inflation outlook.

Instead, we found the RBA could not muster the fortitude to hike. They dithered through the first seven decisions of the year, as you would expect any nine person committee chock-a-block full of strong personalities to do. They consistently sent highly inconsistent signals to the market.

We know that because the economists covering the RBA were saying point-blank that they were confused by its conflicting statements. The first two Statements on Monetary Policy were incredibly hawkish while the Board Statements seemed more dovish. Is that really a surprise when one is prepared by the staff and the other by a committee? Sorry guys, they are not all joined-at-the-hip.

Even the media folks speaking directly to senior members of the Bank, such as Terry McCrann in late July, and, this month, Alan Mitchell, were calling it wrong. After the November meeting Mitchell was telling us in column after column that only a major deepening of the crisis in Europe would force the RBA to cut in December.

Mitchell and his Fairfax colleague, Peter Martin, confidently declared that November was a 'once-off' adjustment of the cash rate back to neutral. Don't bank on any Christmas gifts from the hard-headed RBA. Don't expect the RBA to cut rates because of the mini-budget.

Well, nothing has really changed in Europe. In fact, bond yields plummeted right before the decision yesterday with the Sarkozy-Merkel plan afoot. The domestic data flow was fine. There are some very early indications the highly interest rate sensitive housing market could be about to bounce back strongly with Australia's largest mortgage broker, AFG, reporting its single biggest month for new home loan applications in November since March 2009. The share of investors soared to record levels.

What we got in November was an easy decision to cut. After the low Q3 inflation, and the RBA's preceding signal of a 'decision rule' that would reward a very low print, a cut was always likely. The only fly in the ointment was that the previous downward revision to Q2 was revised right back up! The RBA's Board ignored that and the Q1 data, and decided to hang its hat on Q3.

Again, it was not 'hard' to cut in the sense of it being a politically or socially difficult decision. Furthermore, the markets had priced it. Consumer confidence bounced back to above-average levels in November, and the RBA was showered in praise for providing those ailing sectors of the economy with much needed relief.

Equally, it was not 'hard' to cut in December. The market was fully pricing it. The politicians were calling for it. The RBA Board has now given Swan and Gillard a significant victory in being able to claim that the mini-budget, and weak public demand generally, have emboldened the RBA to loosen policy (assuming the banks actually play ball and pass on the cut). Making your political masters happy is easy. Every vested interest in the country was calling for "insurance" from the Bank over the summer break in case things went awry. In the short-term, it costs you nothing to cut rates. So a nine person committee dominated by private sector business interests is going to have little hesitation in giving out free insurance--to their own constituencies.

What I have learnt is that it's a mistake to listen to Phil Lowe, Glenn Stevens, or Ric Battellino, and think that their their forecasts for the future, and their personal views on the distribution of risks, the dynamics impacting the local economy, and their sterilised vision of how central banking should in theory be undertaken, will prevail through a decision-making process involving a large committee of strong-willed, politically appointed business leaders and the Treasury Secretary.

When Ian MacFarlane controlled the RBA Board with an iron fist, and, in the words one of member, actively stifled debate and dissent, things might have been different. It was easy to be a benign dictator between 1996 and 2007. The economy was cruising along with unprecedented stability. Poor old Glenn Stevens was bequeathed a huge bout of high core inflation in 2007-08, followed by the GFC, higher unemployment, a massive surge in the currency that stretched the domestic economy every which way, and now a bona fide global sovereign debt crisis.

The RBA Board dynamics of today are dramatically different to those that existed in the pre-GFC period. It was easy to be a world-beating Governor (and Treasurer) when you had a 15 year period of global disinflation, high productivity, robust growth, monotonically declining unemployment and uninterrupted growth. Stevens's challenges have been vastly more complex. As have Wayne Swan's, frankly.