Stevens' reserve on rates misplaced

Glenn Stevens has never had less to say. His statement on Tuesday to explain why the Reserve left interest rates on hold was just 383 words. It said nothing about the biggest influence on our economy, China, or the industry that has dominated the economy's growth since 2010, mining.

And, in part, that's because the Reserve, too, is more than usually unsure what lies ahead. It wants to keep its options open.

Last month, it opted to try to make a difference. It cut its cash rate from 3 per cent to 2.75 per cent, taking the markets by surprise. Within three weeks, the Australian dollar tumbled more than 5 per cent to sink below parity with the $US - and, so far, to stay there.

There were other factors in that. The US economy is looking healthier, and Fed governors have hinted that its stimulus might be scaled back, or even reversed. Australia's export prices continued falling. But the Reserve's move played a part.

Time will tell whether Stevens and his board on Tuesday missed an opportunity to reinforce that trend and to deliver a second rate cut that would help the dollar fall sooner and faster.

Since 2010, mining investment has provided roughly half the growth in Australia's economy. The rest of the economy has grown more slowly than our population. But that phase is over. Mining investment is either about to peak, or is already past its peak. Last week's capital expenditure data suggests the latter.

The key issue for policymakers is how to lift quickly the growth of non-mining investment and net exports that we will rely on to take over the baton of growth as mining investment declines.

That is not possible while the dollar remains so overvalued. When it was above parity, the International Monetary Fund estimated that the cost of producing goods and services here was the third highest in the advanced world. And while part of that is due to our higher inflation rates, most of it is the byproduct of an overvalued dollar.

The gap between yields in Australia and yields overseas is clearly a factor in that overvaluation. Unless you think that a rate cut now would result in the economy overheating within a year or two, and inflation getting out of the Reserve's control, why not trim that gap a bit more, and bring the dollar down closer to where you think it should be?

Stevens' statement gives few clues as to why the Reserve chose the course it did. Much of his statement would read equally well had it decided to cut rates again.

It notes that growth in Australia remains "a bit below trend", and forecasts "a similar performance in the near term". Stevens concedes that "unemployment has edged higher in the past year". The Reserve last month forecast growth of just 2 to 3 per cent in the year ahead, with unemployment "drifting higher". Clearly, that is still its view.

Unlike some commentators, the Reserve has noticed the stunning fall in wages growth reported in recent data. The Bureau of Statistics estimates that the economy's wage bill rose just 2.9 per cent in the year to March, down from 7.4 per cent a year earlier. Wages and profits combined have grown just 2.3 per cent in a year. Don't be surprised if Wednesday's GDP figures come out lower than the markets have forecast.

Stevens and his board are still not happy with the dollar. While the trade-weighted index has fallen 8 per cent since peaking on April 12, Stevens implies it's not enough, adding: "As the board has noted for some time, it remains high, considering the decline in export prices ... over the past year and a half."

Moreover, they see no problem with inflation. Nor should they. Take out the impact of the carbon tax and in the year to March, underlying inflation would have been 1.8 to 1.9 per cent, below the Reserve's target of 2 to 3 per cent.

The bank retains its bias towards easing: Stevens' closing comment is a hint that the next rate move is more likely to be down than up. OK, the Reserve thinks the economy is underperforming, the dollar overvalued, and inflation below target. So why not cut interest rates again?

The only explanation given is that Stevens sketches an optimistic scenario ahead. While global growth is now "running a bit below average", he says, there are "reasonable prospects of a pick-up next year". Similarly, he puts a lot of faith in the so-called "green shoots" of growth in demand for new houses, home lending and, arguably, retailing.

The rate cuts to date have "supported interest-sensitive areas of spending", he says, have changed the behaviour of savers and investors, and have generated "some signs of increased demand for finance by households". His conclusion is the key sentence: "Further effects can be expected over time." Well, maybe. But will they be enough to offset the impact on the economy as mining investment turns negative?