SCOREBOARD: Rates rationale

The RBA board's minutes should shed some light on the forces that are driving decisions.

The current Australian monetary policy discussion demands a very close look at the RBA board’s minutes this Tuesday (out 1130 AEDT). I’m the first to admit that I could have this wrong and certainly I’ll probably have a better idea tomorrow, but I think, at this stage, the board is divided and there are significant differences of opinion.

I say this because I found the press release following the April 3 rates decision a very strange read. None of it really made any sense to me. Recall that the board, and this was acknowledged in the April 3 release, had said that "were demand conditions to weaken materially, the inflation outlook would provide scope for easier monetary policy.” Easy enough to understand – it was a very straightforward comment and expectations for rate cuts were rightly brought in given that on the latest data, demand growth is running well above trend and in 2011, was its strongest in four years. A point also acknowledged in the board’s latest press release.

What caught everyone’s attention however, was the comment that the board thought "the pace of output growth to be somewhat lower than earlier estimated, but also thought it prudent to see forthcoming key data on prices to reassess its outlook for inflation, before considering a further step to ease monetary policy”. At first glance as clear a hint as any that rates will be cut.

If that is true though then the board has shifted the goal posts substantially. Recall that the board initially said it required demand to weaken materially. Demand is distinct from output and, as mentioned, is at its strongest in four years. The focus in the latest press release was on output being slower than previously thought. Well then if output is weaker than thought and the inflation outlook allows easier monetary policy, then why not cut at the April meeting? Growth is weaker after all. The only answer that makes sense to me is that the board is divided or if they are not divided then they are all still seriously confused by the strong demand/softer output dichotomy and are awaiting further evidence to see where the economy is truly at.

Two questions the board need to consider. Why is demand stronger than output? Should monetary policy seek to address those differences and can it? Okay, three questions then. Regular readers will already know the answers to most of those questions and I believe the RBA does too. ‘Growth girls’ and boys on the board I’m not so sure though, nor am I convinced that they really want to know. The Australian dollar is too high after all and is crunching growth apparently – well at least that’s what’s being said at the club, and that’s all that matters. Given the run of people demanding lower rates – business people, unions, etc, I think political influences are very strong and probably predominate – thus the change of focus (from demand to output) for some people on the board.

But to answer those questions again. Firstly, ‘output’ as implied by the expenditure side of the accounts is only soft because of the extraordinary strength of imports over the last year and weaker export growth because of the floods. Recall that imports subtract from GDP or output growth (almost 3 percentage points in 2011). Does strong import growth imply a weak or sub-trend economy? Sensibly the answer is no. And it’s not a subjective answer. What about the industry side of the accounts? Here again the apparent softness is an illusion, brought about by a very weak March quarter last year (floods). In particular, manufacturing output is growing at an above trend annual pace of 3.5 per cent. To suggest that manufacturing is being crunched is an outright lie. Most of the weakness here has been in agriculture, utilities, and administrative services. Indeed in the absence of the flood affected March quarter, growth by industry is running at an annualised 3.6 per cent – well above trend.

The answer then is that ‘output’ appears weak largely because of floods and strong imports. That is a fact and it is the reason why we’ve seen 75,000 jobs created in 2012 so far. It is why the unemployment rate still sits at an extraordinary low of 5.2 per cent. A rate cut cannot fix a weakness that is illusory. For the RBA board not to recognise this, raises serious questions about their competence and the policy decision making framework. Given this, monetary policy should not seek to address any supposed discrepancy between growth and demand. Neither has weakened materially – or even weakened. Elsewhere of course we are seeing the US economy accelerate and China is still growing at a very strong pace.

Otherwise for Australia we see car sales for March on Tuesday and first quarter trade prices on Friday. In the US, data includes the April Empire manufacturing survey, US retail sales (March) and business inventories. Tomorrow we get housing starts and industrial production (both for March) and then Thursday we get the Philly Fed index (April), initial jobless claims and existing home sales (March).

As for other data around the globe there is a reasonable amount. In the central bank space, the Reserve Bank of India meets tomorrow. Also on Tuesday we see UK and Eurozone CPI (for March) and the German ZEW survey. UK unemployment and EU construction output is out on Wednesday. While Kiwi first quarter CPI is out on Thursday. This is definitely worth a watch, even if, like me, you think it would be best if NZ joined the Commonwealth and so shouldn’t have its own CPI. A truly magnificent country for sure and it’s only fitting that Australia should own it. But, the point is, it can often have a decent correlation to Aussie CPI. For what it’s worth, the market looks for a modest 0.6 per cent rise. Other than that we see Japanese trade data (March) also out that day. Friday then sees German producer prices, the well-respected IFO survey (April), UK retail sales and Canadian inflation (both March).

Adam Carr is a leading market economist. See Business Spectator's glossary for definitions of technical terms used in SCOREBOARD articles.

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