RBA keeps rates lower for longer

The Reserve Bank of Australia (RBA) left rates unchanged at its May board meeting and offered a firm statement that they will likely remain that way for some time. The conservative approach recognises that the Australian economy has yet to meet its toughest test -- and until it does rates should remain at a low level.

The cash rate was held at 2.5 per cent in May, the eighth consecutive month without a rate move, and based on the RBA’s inflation outlook the bank has inferred that rates could be left unchanged for a couple of years.

The RBA notes that “inflation is expected to be consistent with the 2 to 3 per cent target over the next two years”. With a subdued labour market and wage pressures non-existent, inflation on non-tradeable goods is likely to remain contained for some time.

The exchange rate does pose some upside risk, though the RBA believes that inflation could remain within the band even if the dollar appreciates.

My view is that annual inflation could tip a little over 3 per cent in the June quarter but the pick-up will be temporary. There is also very little that the RBA can do to mitigate foreign drivers of inflation and any attempt to do so will likely be met with failure. 

The RBA should be willing to tolerate higher inflation on tradeable goods if it helps boost the non-mining sector and facilitate the rebalancing of the Australian economy. The RBA maintains that the exchange rate is “high by historical standards” but a little more inflation is a small price to pay for a stronger economy.

The housing sector remains strong, with prices continuing to rise at a rapid pace across the east coast. But building approvals may have already hit their peak and the boost from dwelling investment may not prove as big as the RBA hopes (A house bet that may not pay off for the bank; May 5). Nevertheless, an overheated housing market remains the sole justification for rates to rise.

The RBA said that “resources sector investment spending is set to decline significantly”; I have noted that the collapse in mining investment could leave a hole in GDP of around 3 to 4 percentage points. Unfortunately, “signs of improvement in investment intentions in other sectors are only tentative.”

With sharp cuts expected in next Tuesday’s budget, I’d be surprised if businesses didn’t become a little more tentative about the economic outlook. Consumers certainly have, with consumer sentiment pushing towards its lowest level since the global financial crisis.

Based on leaks, the budget cuts could lead to the sharpest contraction in government spending in 50 years (The real danger in Hockey’s cuts; April 28).

The statement by the RBA should put to bed any views that rates will rise in the near term. The RBA’s forecasts are often inaccurate but it is clear that the board is taking a forward-looking approach to policy.

The bank’s primary concern isn’t the unemployment rate in March or inflation in the June quarter but business investment and government spending next year and whether the non-mining sector is sufficiently strong to drag the Australian economy into a new era of prosperity.

Its conservative approach to policy recognises that the Australian economy has yet to meet its biggest challenge and until that begins rates should remain at a low level. Whether the RBA holds its nerve in the face of an overheated housing market is another thing but for now the board couldn’t be clearer: expect no rate rise in 2014.