The RBA's inflation temptation

Property Observer

NAB's highly regarded interest rate strategist, Peter Jolly, thinks that an RBA rate cut in February is only a 50:50 bet. I agree. Frankly, I see no need to cut rates at all. I don't buy the global recession line. And I am still worried about global (and thus Australian) inflationary pressures, especially in the medium-term.

As one portent, US core inflation has started bubbling up again: over the 2011 calendar year, headline inflation in the US rose by 3 per cent while core increased 2.2 per cent – both above the US Federal Reserve's implied target.

I certainly don't agree with Professor John Quiggin, who yesterday published an op-ed arguing that the RBA should drop its singular inflation target and instead focus on targeting economic growth (or nominal GDP). Central banks should concentrate, laser-like, on two things only: price stability (viz., inflation) and financial stability. Leave the rest to fiscal policy and the politicians.

But forgetting what I think, because, in case you had not noticed, I am not the RBA, my best guess at this stage is, like December, February is a very 'line ball' call for a eager-to-please, financial markets-enraptured central bank (it shouldn't be, but it is). Anyone claiming it's a 'done deal' has not eaten their Weet-Bix for brekkie.

One key wrinkle is this: if you believe that the four major banks – they are the financial system these days and really all that counts – are entitled to maintain their current world-beating returns on equity, and should not have to eat any of the current funding cost increases (or heaven forbid, cut staff salaries), then an RBA rate cut in February will be all about major bank margin preservation. (And do you get the irony? Remember bank profits have nothing to do with the RBA's cash rate, or so we were told!)

All the hoopla around the major banks shedding a few staff is simply a PR campaign to explain to the public that times are very tough. It is the first salvo in a renewed attempt to maintain or expand major bank net interest margins, which are getting squeezed by higher funding costs. As I have pointed out too many times to count, there is another alternative: our government-guaranteed banks could simply target lower returns, lower profits and lower margins in recognition of their substantially lower risks (as a function of explicit taxpayer guarantees, new RBA liquidity facilities, and lower leverage).

If the RBA cuts, it is entirely possible the banks pass on less than half, if any. So why cut in the first place? We've had two in succession already, which have yet to have a material impact – in fact, rate changes typically take two years to have their full effect. And the RBA is the first to admit it cannot forecast the future. December was a weak-at-the-knees, let's dole out some insurance for our banking and financial market buddies, moment.

The RBA has time on its side. The one real rider to this is inflation. And it is a D-Day of sorts for the February meeting. If core inflation prints super-low – say 0.3 per cent or less again for the fourth quarter – and the third quarter numbers don't revise up, then I would agree with the many newly-minted-doves (wink, nudge HSBC's Paul Bloxham!) that the evidence is growing that the RBA can afford to furnish the economy with more rate relief. I still wouldn't cut myself, but that's just me. I care about savers, as well as borrowers.

Anywho, here is what NAB's Peter Jolly has to say:

"The RBA's February 7 decision…remains a close-call. [Yesterday's] labour force report didn't give us any fresh leads, as while employment growth is weak – exactly zero jobs were created in 2011 compared to 365,000 in 2010 – a bit surprisingly the unemployment rate has remained steady around 5.2 per cent for the past six months. So downward pressure on wages and inflation remains modest. Data to watch will be Wednesday's Q4 CPI (NAB economists expect a benign increase of 0.5 per cent quarter-on-quarter and 2.4 per cent year-on-year) and then December's NAB Business Survey Tuesday week…All up, a February 7 rate cut remains close to a 50:50 call at this stage. Market pricing little changed over the week at 84 per cent."

This article first appeared Property Observer on January 20. Republished with permission.