There was unanimity in the market ahead of today’s Reserve Bank board meeting that there would be no change to official interest rates. The market was right, but there may not have been quite the same unanimity within the boardroom.
Going into the meeting it was probable that rates would be left unchanged, but not certain. One only has to read Glenn Stevens' statement after the meeting to understand why a change was possible.
While the world is relatively stable, although Europe remains "a potential source of adverse shocks for some time", growth in China has (as it intended) moderated and commodity prices are "noticeably off their peaks". Australia’s terms of trade have also peaked, but remain high.
While growth in Australian domestic demand was at its fastest for four years last year, output growth was below trend over the year and ‘considerable’ structural change was occurring. Labour market conditions have also softened, credit growth remains modest, the housing market remains soft and the exchange rate remains high.
In fact, in the non-resource side of the economy conditions are tough. Retail sales are flat-lining, housing prices have weakened, non-mining construction has slumped and job losses in the manufacturing sector are swelling as businesses are being forced to restructure in response to weak demand and the exchange rate.
And, in prospect – if Wayne Swan actually delivers on his promise/threat – is the mother, and father, of all contractionary budgets. Oh, and the carbon tax.
Stevens said today that in underlying terms inflation was around 2.5 per cent last year, and currently expected it to be in the two to three per cent range over the next one or two years, ‘abstracting’ from the effects of the carbon tax and including an assumption that productivity growth in the economy will increase "somewhat" as a result of the structural changes occurring.
"At its next meeting the board will have the opportunity to reassess the outlook for inflation, taking into account not only data on demand and output but also forthcoming information on prices.
"The board eased monetary policy late in 2011. Since then its judgement has been that, with growth expected to be close to trend, inflation close to target and lending rates close to average, the setting of monetary policy was appropriate.
"The board’s view was also that, were demand conditions to weaken materially, the inflation outlook would provide scope for easier monetary policy.
"At today’s meeting the board judged the pace of output growth to be somewhat lower than earlier estimated but also thought it prudent to see forthcoming key data in prices to reassess its outlook for inflation before considering a further step to ease monetary policy," he said.
In other words, if the economy continues to show weak growth and inflation remains dormant the RBA is now more inclined to cut rates than hold them.
That’s a very clear signal to the market, and perhaps the major banks.
The RBA’s execution of monetary policy has become slightly more complicated since the banks, led by ANZ, quite recently decided to move their rates independently of the central bank. That means the RBA needs to second-guess their response to its decisions to ensure it sets official rates at a level that will have the desired impact on the economy.
It may be that the RBA chose to sit on its hands today in order to see what ANZ might do when it conducts its monthly review of its rates on Friday week. Alternatively, the clear signal that it is considering reducing official rates next month might be designed to encourage the majors to wait until then before deciding how much of a rate cut to pass through to customers.
The RBA would be well aware that while funding costs – both wholesale and deposit funding – have fallen back a little from their peaks relative to the cash rate, they are still higher than they were in the middle of last year and there has been a modest contraction in banking interest margins in recent months that the banks will be reluctant to see continue.
It is politically easier (although not easy or painless) for the banks to hold back a small portion of an official rate cut than to unilaterally make out-of-cycle rate rises so the RBA’s signalling might cause the majors to wait. If they were to move independently, of course, that would help the RBA judge how much of a rate movement was needed to ensure that the net outcome had its desired impact.
The other virtue in holding rates steady until next month’s meeting, of course, is that the RBA will by then have a clearer understanding of whether Swan’s horror budget is truly going to be horrible and will be in a better position to make a judgement of how much, if any, monetary policy easing will be required to try to blunt the effects of the politically-driven promised return to surplus on the already vulnerable non-resource sectors of the economy.