The Reserve Bank of Australia is naturally pleased with how the economy is responding to low interest rates. However, there remains considerable uncertainty to the outlook -- including a high exchange rate, the prospect that China’s economy will slow and excessive optimism in the housing market -- that will make it difficult for the RBA to act with confidence during 2014.
RBA Governor Glenn Stevens’ speech at the 17th Annual Credit Suisse Asian Investment Conference made it clear that the bank intends to keep rates unchanged for a number of months. Despite some stronger data since it last met, the Reserve appears more than happy to wait and see whether the economy continues to respond to low rates.
In a generally upbeat speech, Stevens reiterated the standard RBA talking points from recent board meetings: residential construction is set to boom, export growth is strong and there is tentative evidence that the economy is rebalancing away from relying on the mining sector. The bank is understandably pleased with how the economy is travelling.
But there remains considerable uncertainty for the Australian economy and Stevens described some of these challenges during his speech.
First, the exchange rate remains at an elevated level.
The RBA’s communications on the dollar have taken an unusual turn in recent months. Late last year the central bank strongly indicated a desire to push the dollar lower, but that initial momentum has been lost and now the Australian dollar is at its highest level in four months.
What could explain this about-face? Either the RBA no longer believes that the exchange rate is important to the rebalancing process (the dollar is no longer ‘uncomfortably high’) or it believes that communication alone cannot provide a sustainable depreciation (Does the RBA really want a lower Aussie dollar?; March 25).
I’d be highly surprised if it was the former. In fact, it would be extremely difficult to argue that the dollar is sufficiently low to encourage a smooth transition when mining investment collapses. Consequently, we can only conclude that the RBA has given up on trying to push the dollar lower through sheer force of will and instead has moved on to simply crossing its fingers and hoping for the best.
Second, there is an increasingly uncertain outlook for China.
There has been growing speculation about Chinese debt and its ‘shadow’ banking system, which has prompted several analysts to downgrade their Chinese outlook over the next couple of years.
If that was to eventuate, it would slow growth in Australian exports and push the terms of trade lower. However, naturally there remains considerable disagreement; for example, Peter Cai believes that the Chinese government is well placed to respond to any slowdown (There will be no Minsky moment for China; March 25).
But as Stevens acknowledges: “China is now the largest or second largest trade partner to most significant economies.” Even a modest slowing of growth could have a significant effect on the global outlook for developed and emerging economies alike.
Third, political and monetary uncertainty in the US has declined in recent months.
The taper has gone about as well as one could expect, while Congress has mostly stopped working against the US recovery, though it’d be nice if it could extend emergency unemployment benefits at some point. At the very least, the threat of austerity is no longer weighing on the US outlook.
But while some political uncertainty has waned, Stevens makes mention that a geo-political shock -- think along the lines of a deterioration of the Ukraine/Russia situation -- could lead to a global retreat from risk-taking and a significant slowing of the global economy.
Though such an event remains what economists call a tail-end risk (something highly unlikely to happen), it is the type of event that wasn’t on anyone’s radar just a few months ago but is now worthy of consideration.
Fourth, there is uncertainty surrounding when mining investment will collapse.
Everyone knows that mining investment will collapse but there is considerable uncertainty surrounding the extent of the collapse and when it will occur. The RBA has set rates so low not because current conditions necessarily warrant it but because it needs to create momentum in the non-mining sector for that moment when mining investment deteriorates.
Fifth, rapidly rising house prices threaten to compromise the bank's desire for a low interest rate setting. The RBA is pleased with the rise in lending activity and the number of building approvals, but it has made it clear that a further boost in investor demand would not be desirable (Investors test the RBA’s homing instinct; March 26).
House price growth, particularly in Sydney and Melbourne, appears to largely be a speculative phenomenon and the RBA has said it will keep a close eye on developments. But it remains a difficult balancing act to keep rates low enough to encourage business investment without encouraging risky speculation.
The Reserve Bank will be considering all of these risks -- and many others -- when it next meets. The biggest immediate challenge is trying to ensure that there is sufficient momentum in the non-mining sector to offset the eventual collapse in mining investment.
This process has been made all the more difficult by a stubbornly high Australian dollar and rapidly rising house prices. Unfortunately, the most likely factor to drive both these indicators down is the Chinese economy slowing, but if that eventuates it would offset much of the benefit of a lower exchange rate.
The RBA will be pleased that the economy continues to show signs of rebalancing and that most sectors of the economy appear to be responding to low interest rates. But the bank knows that its real challenge doesn’t begin until the collapse in mining investment truly gets underway, which is why it is happy to keep rates low for now.