RBA keeps its powder dry

It looks like Glenn Stevens' unorthodox decision to hold rates was a good one – with commodities prices and the global economy hanging in the balance, the RBA has preserved its precious firepower.

Glenn Stevens departed with a tradition he established when the Reserve Bank decided, at the first Cup Day board meeting since he became governor six years ago, to leave official interest rates unchanged. It is, however, probably good news.

When the RBA cut rates by 25 basis points last month it did so, according to its minutes, because of a perceived further softening in the global economy, the steep decline in commodity prices, the bring forward of the peak of the mining investment boom and a relaxed attitude towards the prospect of inflation.

Today it was somewhat more sanguine about the economic environment. In his statement after the meeting, while Stevens said global growth was forecast to be below average for a time, risks to the outlook remained on the downside and economic activity in Europe was still contracting, risks elsewhere ‘’seem more balanced.’’

After this week’s G-20 meeting in Mexico the finance ministers and central bank governors said downside risks to the global economy remained elevated, partly because of possible delays in implementing policies to stabilise the eurozone, the implications of the ‘’fiscal cliff’’ in the US, securing the funding for Japan’s budget, weaker growth in some emerging economies and the potential for more supply shocks in commodity prices.

Since the last board meeting, however, there have been stronger signs that the US housing market and the economy more broadly is turning up while the slowdown in China that developed as this year progressed appears to have bottomed in response to relatively modest stimulatory measures by the authorities.

That has flowed through to more stable commodity prices, which have generally (with the exception of thermal coal, probably for structural reasons) regained some of the significant ground they lost as China slowed. Iron ore prices, which had dipped below $US90 a tonne, for instance, have recovered to just over $US120 a tonne and metallurgical coal prices have also edged back up.

The RBA did, however, say that the terms of trade are now about 13 per cent off their highs – last month it was 10 per cent – and while it also said they were likely to remain historically high it is now saying the mining investment boom will peak next year at a lower level than had been expected only six months ago.

‘’As this peak approaches, the board will be monitoring the strength of other components of demand,’’ Stevens said. Those ‘’other’’ components aren’t exactly firing on all cylinders today.

The RBA now says the stronger levels of consumption growth in the first half of this year (supported by the Gillard Government’s latest cash splashes) were temporary, although there were some signs of ongoing growth. A return to very strong growth in consumption was unlikely, Stevens said.

Investment in dwellings had been subdued for some time but in recent months there had been some signs of a prospective improvement. Non-residential building investment had remained weak and public spending was forecast to be subdued.

The cumulative impact of the RBA’s three rate cuts, totalling one percentage point, this year and 1.5 percentage points in the cycle that started in November last year, does appear to be putting a floor under the housing market and still-weak retail spending levels. The weak signs of improvement make the case for waiting at least another month before acting again.

Stevens also noted that recent inflation outcomes had been slightly higher than expected, buttressing the case for waiting and watching even though the RBA believes inflation is still at levels consistent with its medium-term target and that softer labour markets and unemployment that is edging higher there will be pressures on labour costs outside of the resources sector.

Even in resources, the abrupt break in commodity prices and the miners’ response – mothballing planned projects, deferring expansion plans and even shutting down existing mines – means some of the heat on costs and competition for labour will diminish.

The RBA remains concerned about the disconnect between commodity prices and the Australia dollar, which have historically been closely correlated. There have been reports suggesting the RBA has been trying to ‘’lean’’ against the dollar given the damage the strong dollar has been doing to the non-resource sectors of the economy.

The RBA is still waiting to see how the effects of its earlier rate reductions play out (monetary policy has long lead times before its impact shows up) but came to the conclusion that with the data on prices slightly higher than it expected and recent data on the global economy slightly more positive it could afford to sit on its hands and preserve firepower that, while it has diminished over the past year, is still far greater than that available to most other central banks.

If the dollar stays up, China’s growth rate remains subdued and the fate of the eurozone remains balanced on a knife’s edge it is probable that there will be some more rate cuts, with most economists expecting something more either next month or at the RBA’s February meeting.