What the RBA is saying behind closed doors

No outsider knows how the Reserve Bank of Australia views the flood of data and events over the last 10 days, especially the key data released after its Board meeting last Tuesday. The local news has been complemented by information from overseas which confirmed a further slowing in China, more sluggish news on US jobs, the radical bond buying program from the European Central Bank and generally weak data.

While no one knows how the RBA's views are developing, here is how a conversation between RBA Governor Glenn Stevens and his Deputy, Phil Lowe, may have gone in the RBA's tea room.

Glenn Stevens: Phil, I reckon that things are a little weaker than our models are telling us. How sure are you that GDP growth will remain near our forecast of over 3 per cent for the next year or two with interest rates where they are?

Phil Lowe: Well Glenn, we were assuming over 8 per cent GDP growth in China and only a gentle fall in the terms of trade. These two misses alone will make it tough to lock in that 3 per cent.

Stevens: Gentle? What do you mean?

Lowe: If I can use iron ore prices as a proxy, we were assuming iron ore prices easing back and then holding at about $A110 a ton. It's about $A90 now. It also looks like Chinese GDP will be nearer 7 per cent so we were clearly too optimistic.

Stevens: Hmmm. What of the infrastructure stimulus that was just announced in China? What sort of boost to growth will that deliver?

Lowe: Those projects are all well and good, but there is, even for China, a lag before the projects get started and when they do start - they are projects that will take years to build. The stimulus is therefore not at all immediate.

Stevens: That's what I thought.

Lowe: Milk Glenn?

Stevens: Yes, the skim. Thanks. And I don't think that the unemployment rate is telling us how the labour market here is truly performing. The data after our board meeting last week shows that in the last three months, employment has fallen by 27,000 in total. Can you remind me what ANZ job ads are doing and what that means for jobs?

Lowe: ANZ job ads have been falling for almost half a year and if they stay this low, we won't see any jobs growth for the remainder of the year. Unless job ads turn higher, we could actually see more job losses early in 2013.

Stevens: That's a worry. While I am continually surprised by the unemployment rate staying just above 5 per cent, I think we need to do a bit more work to see just how much slack there is in the labour market. If, as I suspect, the fall in the participation rate and hours worked is considered, we can set policy to grow the economy a bit more without much risk of a pick up in wages and inflation.

Lowe: One lump or two?

Stevens: Make it two, I need a sugar hit.

Lowe: Gov, I am increasingly worried about the data we have for the economy after the June quarter. Retail sales, building approvals, housing finance and credit growth are all falling. Business confidence is also down a bit.

Stevens: Do you and the team have any early signs about what the September quarter GDP growth rate might be?

Lowe: At this stage, we're looking at something below 0.5 per cent for the quarter but if government demand falls a bit more than we think, it could get close to zero.

Stevens: That's a concern. I was actually speaking to Martin Parkinson the other day. He told me in no uncertain terms that the government is deadly serious about cutting spending in the Mid-Year Economic and Fiscal Outlook to the point where it is guaranteed to bring the budget to surplus.

Lowe: So the government will still be cutting about 1 percentage point from GDP?

Stevens: At least. And that was just the Commonwealth government's spending contraction. Martin was also saying that some of Treasury's preliminary work on the state budget cuts were pointing to overall public demand cutting more than 1.5 percentage points from GDP in the next year. The spending cuts from the States will also take a lot of steam out of the economy.

Lowe: Wow. If we were to plug that directly into our spreadsheets, GDP growth will be near 2 per cent in 2012-13 and with that, the unemployment rate will be up to around 5.75 per cent early in 2013. What about the Australian dollar? No one is acting on our hints that it is overvalued.

Stevens: True. It's still around 1.04, which is too high. We need to be more direct with our communications. Just saying that the level of the Australian dollar is no longer reflecting the change in the terms of trade is not sinking in to the markets. I reckon the next time we talk on the subject, we need to be more direct.

Lowe: Our latest estimate is that the dollar is about 10 per cent over valued. While we all know that these currency true-value models are not altogether helpful, when we have a 10 per cent deviation like now, we are pretty sure that we have correctly calculated the direction of the mispricing. Right now, it's pointing to the dollar being too high.

Lowe: Another cup?

Stevens: Did you say cut? Yep, we need it.