Rates pragmatism hits the sweet spot

Now the Reserve Bank is moving to a more accommodative monetary policy stance, Australia's outlook to the end of 2013 is a near perfect economic scenario.

The Reserve Bank will deliver more interest rate cuts in the months ahead, with another 25 basis point move lower in November more likely than not.

Yesterday’s 'no brainer' to reduce the cash rate to 3.25 per cent which, curiously, so few analysts anticipated, was a recognition from the RBA that domestic inflation pressures are flat at a low level. The RBA’s dovish view on inflation is complemented by the world economy screaming in pain about a series of downside risks and on the domestic front, an acknowledgement that the labour market is soft with employment falling in the last three months.

It wasn’t always like this. During 2012, the RBA has been vocal about global economic growth being "around trend”, the Chinese slowdown was not a worry because it was "as intended” and the labour market was still reasonably tight because "the unemployment rate remained low”.

The about face from the Reserve Bank is good news and is further evidence of its pragmatism and flexibility. When it gets it wrong, the bank has acknowledged its errors with sudden and often unexpected interest rate moves. In addition to yesterday’s rate cut, the easings in May and June were shocks to the market but reflected well on the RBA's quest to do the right thing.

The objective of easier monetary policy is to encourage private sector borrowing, investment and spending and discourage private sector saving. In isolation, this translates higher growth and higher inflation than would otherwise be the case. I would like to emphasise "in isolation” because the interest rate cuts, which now total 150 basis points since November 2011, have been delivered with the Reserve Bank giving consideration to a huge array of unfolding events and new information which point to generally weaker activity and downside risks

Those events include confirmation of a severe tightening in fiscal policy from the Commonwealth government in 2012-13. The government is withdrawing spending and activity from the economy as it returns the budget to surplus. This leaves room for the private sector to expand at a faster pace without there being any upward pressure on inflation. At the same time, many state governments are cutting spending, which all points to public demand in total slicing at least 1.5 percentage points from GDP growth in 2012-13. The Reserve Bank acknowledged this in its recent Statement on Monetary Policy.

The bank's decision to ease monetary policy is also linked to the global policy easing from most central banks. It would be odd if the RBA stood at the sidelines while the likes of the US Federal Reserve, the European Central Bank, the Bank of Japan, the People’s Bank of China and others were pump priming their economies with unprecedented stimulus. These central banks and others are easing policy because their economies are fragile and weak.

It would be almost impossible to think that the reasons for this mass global easing – weak growth with downside risks – would not impact on Australia in some way. The Reserve Bank and some shrewd analysts knew this, which is why it was a surprise that the rate cut was a surprise.

It is also clear that inflation is becalmed. The high Australian dollar, lower commodity prices, growing slack in the labour market with employment and hours worked weakening are all vital bits of news for the RBA board. The TD-MI monthly inflation gauge suggests that outside the one-off effects from the price rises from the introduction of carbon pricing, inflation remained very low into the September quarter. Underlying inflation seems to still be running near 2 per cent.

After the dust settles from the recent global policy changes and now the Reserve Bank moving to a more accommodative monetary policy stance, the scenario for the Australia through to the end of 2013 is annual growth in real GDP bouncing around 3 per cent, plus or minus a few tenths of a per cent, underlying inflation (excluding the temporary effect of the carbon price) running in a 2 to 2.5 per cent band and the unemployment rate ticking up towards 5.5 per cent but probably not going much higher than this.

It is a near perfect economic scenario that will be enhanced if even easier monetary policy down the track can lift growth sufficiently to see the unemployment track back to 5 per cent or even a touch less.

The risks to the near perfect economic outlook are evenly balanced. On the upside, we could see a more favourable outlook for consumer spending and housing, aided by easier monetary policy and a change in sentiment from consumers who have been rebuilding their savings over recent years. Australia needs more housing construction and the latest policy settings bode well for an upturn starting about now.

The downside risks are linked to ongoing Australian dollar over-valuation, further caution from consumers and an even more aggressive fiscal easing. There is a lot of bad news priced in from the weak world economy, although a sharper downturn in China and with that, even sharper falls in commodity prices would be bad news for Australia.

Whatever happens, the Reserve Bank has shown yet again its generally terrific management of monetary policy. Sometimes it might be a little slow to react to a run of news, but when it realises its misreading, it quickly changes tack. Well done the RBA.

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