In May last year we released a somewhat controversial forecast that the RBA's overnight cash rate, which had just been cut by 50 basis points to 3.75 per cent, would eventually fall to 2.75 per cent by around year end or possibly early into 2013.
We have not changed that forecast. In fact we have only changed our forecast once since July 2011.
The December quarter CPI report released this week showed that momentum in core inflation has picked up a little. For the first half of 2011 and the first half of 2012 six-month annualised core inflation was running at 2 per cent – the bottom of the bank's 2 to 3 per cent band. That has picked up to 2.6 per cent for the second half of 2012 although that needs to be adjusted for a carbon price effect which probably lowers it to 2.4 per cent (around the middle of the range).
We assess that development as slotting inflation into the 'neutral' category. When core inflation was running at the bottom of the band there was more scope to ease rates and, to the extent this reflected weak domestic demand and competitive pressures from a high Australian dollar, some added urgency to adjust policy.
Global developments also reduce that urgency. Financial prices are booming and global confidence in financial and important commodity markets has been boosted.
This is exemplified by the 75 per cent rebound in iron ore prices since September; the fall in credit default swap spreads for most euro area countries to their lowest level since January 2010; and the 13 per cent increase in global equity prices over the last year. On face value it would appear that optimism around global economic conditions and the 'neutral' CPI reading might scuttle our current expectation that the Reserve Bank will decide to cut rates again by 25 basis points in March.
However this needs to be balanced against the accumulating evidence that rate cuts are providing a much less potent stimulus domestically compared to previous easing cycles. To date the response of the Australian economy to the 175 basis points of cash rate cuts has been underwhelming to say the least. This resistance indicates there is room to cut further.
Previous easing cycles ended when the authorities assessed that the response of the economy to the lower rates was adequate. The charts track a number of key variables (based at 100 for the beginning of each easing cycle) through the first 12 to 14 months of the easing cycle. The number of months is based on data availability for the current cycle which began 14 months ago. Variables chosen cover confidence; the housing market; retail sales; and the labour market. These are all variables which could be considered to be most likely to respond to interest rate changes.
To be sure both previous cycles cut rates harder than we have so far seen in this cycle. In 2001-02 the cash rate was cut by 200 basis points from 6.25 per cent to 4.25 per cent. In 2008-09 the rate was cut by 425 basis points from 7.25 per cent to 3 per cent compared to the current cycle which has seen 175 basis points in cuts – from 4.75 per cent to 3.0 per cent.
Consider the response of house prices in this cycle in comparison to earlier cycles (Chart 5). House prices increased by 20 per cent in 2001-02 and 10 per cent in 2008-09 whereas in this cycle they have increased by a net 1 per cent – having fallen by 3 per cent in the early stages of the cycle and recently recovered by around 4 per cent.
The strength of the response in the previous cycles justifies those cycles as 'short and sharp'. Equally, the nature of the response to the current cycle points to it likely being considerably longer. If we are right and there is another cut in March then this current cycle will have extended by at least 16 months compared to 11 months (2001) and 7 months (2008-09). Equally, a decision to defer in March, due to the improving global environment, should not necessarily signal the end of the cycle.
But monetary policy can have long cycles. Recall for instance the extended tightening cycle between 2002 and 2008, which was only interrupted by the global financial crisis.
Confidence measures are very important for policy. Much will depend on the sustainability of the current upswing in the world economy. For example, over the 2001 year, an average of 13 per cent of respondents in the Westpac-Melbourne Institute Consumer Sentiment Survey recalled overseas news items compared to 22 per cent in 2008-09 and 35 per cent in the current easing cycle. The assessment of the news was, not surprisingly, quite negative in each period but significantly more pessimistic in this cycle than in the two earlier ones. In particular, the periods when the European crisis was most extreme really stood out.
Compare the response of the typically lagging variable – the labour market – over these easing cycles (Charts 6; 7; and 8). Firstly, after rising in the initial stages of the two earlier cycles there was clear evidence near the end of the cycles that the unemployment rate was on its way down. In the current cycle, after a reasonably steady response in the early stages of the cycle, the unemployment rate now appears to be edging up gradually. Hours worked lost some initial ground and is not showing the clear evidence of improvement which was apparent near the end of the previous cycles. Furthermore, despite initial deterioration there was clear evidence that peoples' assessments of their job security was markedly improving in the latter stages of the earlier cycles – not so in the current cycle.
A reasonable conclusion from these observations is that this easing cycle is quite different from the two previous cycles. The response of the economy has been quite muted and the risks of overstimulating, which the authorities might have detected in the previous cycles, are just not there. One important factor is that overseas developments appear to have played a more restraining role in this cycle than in the past and global developments will be an important factor in determining the outlook.
The most important conclusion from this note must be that despite the cash rate reaching record lows for now there seems to be little risk to pushing rates lower.
Bill Evans is Westpac's chief economist.
WEEKEND ECONOMIST: The endless easing
A study of previous monetary easing cycles shows that this one is quite different. Despite record low rates, there appears little danger of overstimulating.
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