Tough-talking RBA takes the cautious approach

Following a month off, the Reserve Bank of Australia has returned in 2014 with a slightly more upbeat interpretation of the domestic economy. But although low lending rates are boosting activity, the RBA is unlikely to make a move anytime soon.

In the minutes for its February board meeting, the RBA said that if the ‘economy evolved broadly as expected, the most prudent course would likely be a period of stability in interest rates’. It is a distinct change in tone from its last board meeting, when it kept the door ajar for further cuts if appropriate.

In a sign of how quickly things can change in financial markets, the Australian dollar has appreciated around 3.5 per cent against the US dollar and almost 2.5 per cent against the trade weighted index since the board meeting took place.

The exchange rate is still well below its peak during 2013 but has once again returned to a level that the RBA has previously described as ‘uncomfortably high’. Much of the momentum gained through the RBA’s tough talk has subsequently been lost.

The exchange rate remains a central concern for the Australian economy and the RBA board members.  It is a central pillar upon which the outlook for the Australian economy balances. But with inflation at an elevated level how credible can the RBA’s tough talk really be? Traders appear to have already made up their minds.

On a positive note, the RBA does see increasing evidence that ‘the expansionary setting of monetary policy was having the expected effects’. Interest rate cuts affect the economy with a significant lag and we are seeing these effects continue to flow through the economy.

Housing activity has picked up, with dwelling investment set to rise on the back of widespread growth in building approvals. Housing loans have also picked up significantly – though the RBA should be somewhat concerned by the level of speculation in the housing market (The cold truth about hot property prices, February 12).

Similarly business lending is on the rise but it appears as though many businesses are using low rates to refinance existing loan balances and deleveraging (Business is nibbling at the RBA’s carrot, February 14). Nevertheless, lending markets are reacting broadly as expected.

The RBA board acknowledges that it is puzzled by the inflation data – which admittedly is not a word one wants to hear from their central bank – but the rise in inflation is likely to be temporary – driven by the depreciation in the Australian dollar. Alternatively, the RBA also suggested that the rise in inflation may simply reflect ‘noise’ or that lower wage growth was taking longer than usual to flow through to consumer prices. Regardless, it appears to be a temporary boost.

The RBA said that forward-looking indicators of labour demand, such as vacancies and job advertisements, had ‘shown signs of stabilising in recent months’ but they expect only ‘moderate growth of employment in the months ahead’.

Since the meeting, the labour market has deteriorated further, with the unemployment rate increasing to 6 per cent – the highest level in a decade. The RBA said the ageing of the population has accounted for around half of the fall in the participation rate over the past few years and this factor will continue to put downward pressure on the participation in the years to come.

The RBA finds itself in a tough situation right now, confronted by rising inflation and a labour market that has deteriorated at a faster pace than most expected. Given its evident confusion regarding inflation and the weak outlook for the labour market, the RBA will be reluctant to raise rates even if inflation exceeds their 2 to 3 per cent target band.

As a result I don’t see too much scope for the RBA to move in the near term. Perhaps more importantly, compelling arguments can be made for both lowering and raising the cash rate.

On the downside, we have the labour market deteriorating at a faster pace than the RBA would have anticipated and the exchange rate remaining stubbornly high. Recent job losses at major Australian organisations paint a pretty bleak picture. If the mining investment cliff arrives while employment is weak and the exchange high then the economy could be particularly weak towards the end of the year.

On the upside, low interest rates are having some effect and the RBA should be somewhat concerned about rising speculation in housing markets. Consumer spending has picked up and dwelling investment is on the rise, business surveys suggest that conditions have improved (though that is hard to believe given businesses are cutting jobs). Not to mention inflation will likely exceed the bank’s target band.

But without any clear signals it is difficult to see the RBA being decisive over the next few months. Instead we should settle for, as the RBA says, a ‘period of stability in interest rates’.