An interest rates Rubik's cube

Property Observer

Since the average Australian family's debt-to-income ratio has risen from 55 per cent in the early 1990s to around 150 per cent today, they've become vastly more sensitive to changes in interest rates. Combine that with the fact that most Australian borrowers are on fully adjustable-rate loans that usually price off the RBA's target rate, and you start to realise that Australia's central bank is facing significant, and perhaps uniquely acute, community resistance to higher rates. (Never mind that numerically speaking there are actually more savers than borrowers.)

This situation is exacerbated by the highly telescoped nature of Australian economic growth. The newly-appointed and self-described "dove” on the RBA board, Heather Ridout, highlighted this on radio during the week: around 80 per cent of the Aussie economy is expanding at an insipid 1 per cent pace while the remaining 20 per cent races along at a spectacular 15 per cent rate. Framed differently, four out of five Australian businesses want rate cuts while one-fifth don't really care. It's like the awesome foursome have one guy rowing at top speed while the remaining three have been given lead oars.

And then we have the government of the day in periodic conflict with Australia's embattled central bank. For decades the convention was that the independent members of the RBA's board set staff pay. While the RBA is part-regulator of, and explicit lender of last resort to, the entire banking system, and many of its alumni have held high office in the private sector, top staff are still paid only a fraction of what they could earn elsewhere.

Possibly because of well-documented clashes between the RBA and the government during the GFC (over the 2008 rate hikes and the deposit guarantees), and the subsequent spectre of an overly hawkish RBA eager to raise rates during 2010-2011, Treasurer Wayne Swan broke with his predecessors' convention and took away the RBA board's pay-setting powers. At the same time, he promised that future governors would not receive Glenn Stevens's ‘out-of-step' $1 million pay packet (ignoring the fact that the average top 10 major bank executive gets about four to five times as much).

Some believe that a parallel assault on the RBA's independence and credibility was the replacement of the two main "hawks”, or inflation-fighters, on the bank's board – Professor Warwick McKibbin and Donald McGauchie – with a manufacturing industry lobbyist, Heather Ridout, who says she prioritises growth over inflation, and a former Labor economic advisor, John Edwards. The appointment of Edwards broke the multi–decade tradition of having at least one politically independent academic expert sitting on the bank's board.

Professor McKibbin's regular criticisms of the government's general policy initiatives doubtless helped convince them that the political costs of elevating academics to the RBA board outweighed the clear governance benefits.

Indeed, it would not be a complete surprise to see Julia Gillard's recently departed staffer and noted RBA critic, Stephen Koukoulas, one day join Edwards (or replace him), assuming Labor still have the power to make this change. Koukoulas notably characterised this month's RBA decision as "candy-arsed”, and has been vociferous in his condemnation of the RBA for not cutting in February.

In light of the dynamics described above, it should be no surprise that the community has been baying for cuts. The Australian and The Australian Financial Review collectively published four opinion pieces immediately before this week's RBA meeting calling on the bank to ease its policy position.

News Limited's Terry McCrann also chimed in declaring that the odds of an April cut were better than 50 per cent, and, more remarkably, that if the RBA governor recommended another pause, which he did, the doves on the board would roll him. In doing so, McCrann acknowledged for the first time that there had been occasional battles on the RBA board when the numerically-dominant doves had knocked-back staff recommendations to hike rates, which is something I had argued occurred in 2011.

Following the RBA's decision to wait for the first quarter inflation data, we have been overwhelmed with columnists from The Australian and The AFR confidently calling a cut in May, and lambasting the bank for misjudging the pulse of growth.

Of course, much of this is predicated on one unusually low GDP print in the fourth quarter of last year. People seem to forget that these numbers can be revised by stunning margins. For example, in the first quarter of 2011 the ABS told us that the economy had contracted by a horrific 1.2 per cent as a consequence of the east coast floods. The latest estimate is a radically more benign 0.3 per cent. It is not inconceivable that the fourth quarter GDP will revise up to signal healthier growth at the end of last year. As UBS's Matt Johnson argues, the growth data tends to revise towards the unemployment rate, which at its current 5.2 per cent level seems to paint a more positive picture.

Those that want lower rates overlook a few other key points. Namely that:

- The RBA cut rates twice only months ago, a move most assess takes one or two years to have its full effect;
- The currency is now 5 per cent below its level at the beginning of March, and, if it keeps falling, will become a source of inflation rather than deflation;
- Australia has high "services” (as opposed to "goods”) and non-tradeables (as opposed to "tradeables”) inflation, with tradeables and goods inflation having been depressed only by the appreciation in the currency;
- The unemployment rate remains just a touch above the Treasury's estimate of its ‘full-employment' level, and has been bobbing around this mark for a year;
- Mortgage rates are actually at or below their long-term averages;
- Core inflation is still smack-bang in the middle of the RBA's target band (not below it), and that this is partly a result of the RBA's historic rate settings;
- We have a carbon tax being implemented this year that many experts think will be more inflationary than the government and RBA forecasts imply;
- Productivity looks low and threatens to boost inflation above the RBA's target band unless it improves;
- The two largest economies in the world, the US and China, are currently growing around their trend pace;
- The global environment is materially better than the RBA had banked on back in December;
- Central banks around the world have printed over $US8 trillion of new money to underwrite government deficits and bailout private banks, which history suggests, can be inflationary.

I think one under-appreciated problem for the RBA is that it is discovering just how hard it is to raise rates beyond their neutral level following the regime change in the economy's interest rate elasticity during the 1990s and 2000s. After more than 20 years of relatively low inflation (care of China flooding global product markets with cheap goods), there are entire generations of Australians who cannot remember what it was like to have high inflation and double digit rates. And these people vote. In 2011 the RBA executive learnt that it no longer controlled its own board, as Ian MacFarlane had done during his easier and more stable reign. Following the governance revolution implemented by a much more open-minded Glenn Stevens, the RBA has unwittingly empowered the vested interests that dominate its board.

With six private sector representatives and a politically-appointed treasury secretary, the RBA has arguably the most inflation-friendly monetary policy committee of any central bank in the developed world. It also just happens to have one of the highest inflation targets in the world, and, just coincidentally, has failed to meet this target during Glenn Stevens' term (core inflation has average 3.2 per cent per annum since the December quarter of 2006).

Given the decision-making constraints the RBA faces, and the fact that it believes it has one main policy goal (price stability), which is spun into a "dual mandate” in the long-run (by arguing that if it keeps inflation low it will help maximise employment growth), logic would suggest that it should cautiously, and only when persuaded with reliable empirical evidence, lower the price of money to stimulatory levels. To be clear, this is because normalising it again, and pushing rates into restrictive territory, is a vastly more difficult undertaking.

Years ago I argued that given the RBA's questionable inflation-fighting track-record since Stevens' term began, and the above-mentioned limitations, it should potentially have an asymmetric response function: all things being equal, the RBA should prefer to slightly undershoot rather than slightly overshoot its inflation target. In practice, the opposite has proven to be the case.

Don't get me wrong: if year-on-year core inflation prints near the bottom of the RBA's target band in a few weeks time, and the labour market deteriorates further, this central bank will be almost certainly be cutting rates in May.

While the lay-fans in the stands may not embrace the decision-making fortitude I advocate here, RBA officials can draw strength from the fact that history tends to be a more impartial judge.

Christopher Joye is a leading financial economist and a director of Rismark International and Yellow Brick Road Funds Management. The above article is not investment advice. This article first appeared on Property Observer on April 5. Republished with permission.