The RBA's timely market salvation

The Reserve Bank was tardy in cutting last year, but has been rescued by an unexpected lift in stock markets. Now it's likely the bank could hold fire for the rest of the current cycle.

The Reserve Bank will leave interest rates steady following the meeting of its board today. A cut will not be seriously considered, to be frank, which means that the gurus on the board will spend plenty of time looking at various scenarios that focus on where monetary policy could and should be in the next six to 12 months. They will consider more long-run issues that help them form views on whether additional rate cuts are going to be needed, or if the more positive economic news unfolding will require interest rates to edge higher sometime down the track.

To be sure, the official inflation rate is very low and many of the lagging economic variables are reasonably flat. In normal circumstances a further interest rate cut would be possible, but the opportunity for the bank to have cut interest rates further was last year. It only half-heartedly took up this responsibility as it dragged the chain with it views on falling and sustained low inflation and in doing so, risked a sub-optimal growth performance for the economy in early 2013.

The risks to the economy from the Reserve Bank's tardiness in cutting rates last year has been saved by the unexpected lift in stock markets, a rally in credit markets and a flood of good economic news on the global economy. Even some of the domestic economic news is unfolding in a way that suggests the interest rate cutting cycle is over.

In addition, the TD-MI monthly inflation gauge shows very clearly an unwelcome uptick in inflation in the last two months, with a rise of 0.4 per cent in December and a further 0.3 per cent rise in January. While there was no doubt some seasonality in these results, they suggest the CPI will rise by around 0.8 per cent in the March quarter.

In itself this is not a problem, but it is elevated and the Reserve Bank will want to make sure this is not the start of an unwelcome inflation lift.

There is also some evidence that house prices and housing construction are starting to lift, even with the drop in house building approvals in December. House prices are edging higher after that worrying weakness in the year or so up to the middle of 2012, and while a house price bubble is not at all likely, it is an issue the bank would want to rail against by holding monetary policy firm.

The other high-profile development in recent months has been the rebound in the iron ore price, now back above $US150 a tonne. This pick-up is being reflected in the Reserve Bank's own measure of commodity prices, which has risen over 5 per cent in the last two months in Australian dollar terms and is at a level that, if sustained in the next few months, suggests an increase in the terms of trade during the first half of 2013.

In addition to these measures, business confidence and consumer sentiment are edging up. The increases are not big, but they are enough to suggest spending, investment and profits will all be solid in the early months of 2013. What’s more, there is a potentially strong wealth effect unfolding from the stock market surge.

Admittedly, the stock market was weak around the middle of 2012 as global risks, the threat of a Greek default, US economic uncertainty, the iron ore price collapse and China slowing were all hitting the market hard. The loss of wealth from the weak stock market weighed on consumer sentiment and with it, spending.

Fast forward to now and the 22 per cent lift in the Australian stock market from the June 2012 low has added around $240 billion to the overall value of the market. This is boosting the value of superannuation assets and will inspire a lift in confidence and spending.

That good news is being tempered somewhat by the labour market indicators which are soft with job creation slowing and the unemployment rate edging up, albeit from tight levels. History shows time and time again, the labour market lags the business cycle so it will probably get a bit weaker before it gets better. The Reserve Bank knows that and will not react to soft jobs data.

Like the Reserve Bank, I will be looking at the business and consumer confidence measure, house prices, the stock market, commodity and global news for my leads on Australian monetary policy. What happens to fiscal policy will also have a bearing on the growth outlook and have an impact on future monetary policy decisions.

For now, it’s rates on hold with the balance of probabilities suggesting that further rate cuts will not be needed in the current cycle.

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