The logic behind a rates surprise

The Reserve Bank's decision to hold rates was a no-brainer, and it would take a brave bank to lift its rates under the current circumstances.

So, the Reserve Bank held interest rates steady at its February meeting, which is what I expected, characterising economic growth as "close to trend” and inflation "close to target”. I had previously argued that holding in February was a no-brainer from a pure policy-setting perspective.

However, the RBA operates in a world of complex practical constraints, the biggest of which is that the RBA’s board is, unusually, dominated by six private sector individuals with a natural bias towards lower rates, and the treasury secretary, who ultimately represents the government of the day and is typically regarded as being "dovish”.

We know as a matter of empirical record that former treasury secretary Ken Henry had battles with RBA board members Warwick McKibbin and Glenn Stevens during the GFC, trying to push the target cash rate much lower than the RBA hawks wanted (its nadir was three per cent).

Accounting for these real-world limitations on the RBA, given its board complexion, I stated that I slightly favoured the RBA leaving rates unchanged.

But rest assured, this was a massive surprise for both the financial markets and most economists. The markets were pricing in an 80 per cent plus probability of a cut only a few days ago, and had gone as high as 100 per cent. Only 3 of 27 economists surveyed by Bloomberg picked today’s decision, which is a telling statistic.

Some, like former prime ministerial advisor Stephen Koukoulas, felt there was a near-certain probability of a 25 basis point cut, and a real possibility that the RBA would cut by twice as much.

And then we have News Ltd’s Terry McCrann, who in four separate articles in the last two weeks stated that the RBA was "almost certain” to cut its cash rate today. I speculated publicly that McCrann was being "worded up” by either a private sector board member, or politicians that were seeking to maximise pressure on the bank to comply.

When McCrann predicts a result with a very high degree of confidence, the financial markets ordinarily fall in behind him. The bank has stated that it does not normally like "shocking” the markets (and expectations more broadly), and will sometimes rationalise its own moves by referencing the fact that the policy change was being anticipated in the markets.

With the recent pick-up in growth in the world’s largest economy, the rebound in the US labour market, which has seen the unemployment rate fall from over nine per cent to 8.3 per cent today, a very benign soft-landing in Australia’s two major trading partners, China and India, and an only so-so domestic inflation report that left underlying consumer price pressure at 2.6 per cent over the last year, sitting on the sidelines and waiting for more information made a great deal of sense.

Indeed, there have been some more positive tinges to the domestic data flows. For example, the ANZ job ads index surged six per cent on Monday to a level that UBS analysis suggests should see unemployment remain static around its currently very low 5.2 per cent rate (see chart).


We have also seen more positive housing data, with national dwelling prices grinding out a slight seasonally adjusted rise over the months of November and December (taken together).

A more worrying development for the RBA has been partial information implying a return of inflationary pressures. The monthly TD Securities-Melbourne Institute benchmark has recorded a strong increase in its core measures of Australian inflation on a three month annualised basis, as the chart below shows.


One interesting question is what the major banks now do. The RBA’s cash rate affects all forms of bank funding, one way or another. It directly affects the circa 60 per cent of funding that is sourced from short-term retail deposits. It indirectly impacts the 30 per cent of funding that is originated from the wholesale markets locally and overseas (via its influence on the yield curve). So the question is: do the banks unilaterally raise rates on the back of claims of higher funding costs? I don’t think so. Maybe ANZ nudges its rates up a tiny amount, just to make a statement.

The fact is, however, that funding costs and financial stresses more generally have plummeted in recent weeks. When CBA issued its $3.5 billion, AAA-rated covered bond in January, it paid a price of 1.75 per cent over the swap rate. Today that same covered bond is trading 36 basis points lower at just 1.39 per cent over the benchmark rate.

The broadest possible measure of Australian financial stresses, which is the "credit default swap index” produced by ITraxx, has declined strikingly from over 220 points in November last year to about 140 points today (see chart).


It would be a brave bank to undertake independent margin expansion in the face of this evidence.

This article first appeared on Property Observer on January 31. Republished with permission.


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