Cold shower time, says Ron Woods

7 November 2005

Cold shower time
Some commentators had expected the RBA would copy the script of foreign central bankers and resume last year’s barking about the need for higher interest rates. Now these were Australian based commentators but one wonders if they know what is happening in their own back yards. Fortunately the RBA appears better informed and in today’s latest quarterly Statement on Monetary Policy they wrote their own script reflecting Australian economic conditions. In short it says official interest rates are going nowhere up or down for a long time yet. Rates are neither too high they believe: “the chance of a more pronounced [economic] slowing has lessened” and “financial conditions at present do not appear to be inhibiting growth in demand and output”; nor are rates too low to prevent consumer inflation: “underlying measures of consumer price inflation'¦appears likely to be contained to an acceptable level in the medium term.'¦[and are] expected to remain consistent with the [RBA’s] target over the medium term”.

I didn’t expect the RBA would copy the foreign rhetoric based upon what our yield curve says. Today our curve is near-flat from cash to ten-year bonds (6 basis points or 0.06%) which is much too flat when compared to long term averages (it has been mostly been inverse since April). The average since the RBA signed a formal agreement in 1996 to target “inflation” the spread has averaged about 70 points; in the last five years the spread has averaged about 50 points. The curve was still inverting until August and began to recover after the RBA dropped the reference that it would be “unlikely that there would be no further [rate] rises”. That is precisely the reaction one would expect from the yield curve from a less hawkish policy. Consequently it is now less inverse than earlier this year and is signalling that it is likely we will escape with a soft landing in Australia. A continued absence of higher rate rhetoric in today’s November Statement should support that outlook.

We have seen that the Australian economy’s growth peaked towards the end of 2003 and began to experience much weaker growth throughout 2004. However recently there has been a pull-out from the sharp economic descent of last year to a soft landing this year. That has been reflected in the yield curve becoming less inverse. I suspect there will be a prolonged period of a sub-trend economy and an absence of any intervention by the Reserve Bank for some time to come. Certainly that was the message from them today; I suggest the interest rate bears take a cold shower.