Taking into consideration the goals of monetary policy and the clear risks associated with a low interest rate environment, the decision to hold rates this week (and next month) should be an easy one. I say should, but judging from the press commentary and the RBA’s minutes I don’t think it will be. More to the point, both industry and the union movement more broadly, are calling for more, aggressive cuts. A cut at some point would appear to be a done deal.
The framework is simple. The objectives of monetary policy are outlined in the RBA act and were elaborated on in an agreement between the Reserve Bank and the government in 1996. This has been redrafted four times subsequently, almost verbatim – most recently in 2010. In that document it was agreed to conduct policy in a way that "will best contribute to”:
– The stability of the currency of Australia;
– The maintenance of full employment in Australia; and
– The economic prosperity and welfare of the people of Australia.
In pursuing these objectives it was decided by the government and the RBA – initially in 1996 but confirmed by subsequent governments – that price stability was "a crucial precondition for sustained growth in economic activity and employment”. In other words that low and stable inflation was the best way to ensure the objectives as outlined in the RBA act and as agreed by the government and the RBA.
With that in mind, I don’t think anyone in good conscience would argue that these objectives haven’t been met. Australia’s economic performance is the envy of the advanced world.
– The currency is stable, regarded as a safe haven by international investors and governments a like – albeit at a rate some in industry don’t like;
– At 5.1 per cent, we are currently very near full employment;
– The nation is prosperous – our citizens have never been wealthier with assets many times debt outstanding. We are buying a record number of cars, we are going overseas in record numbers and we have more material wealth than ever before – TVs, clothes, electronic gadgetry. We are drinking and gambling in record amounts.
This is not a nation in distress and the above highlights one glaring fact – there simply is no need for lower rates, notwithstanding low inflation.
Indeed the case for lower rates completely ignores the objectives of policy and rests on an erroneous interpretation of the inflation targeting regime. Price stability is the target and with this is mind, a range of 2-3 per cent over the cycle is regarded as the best way to achieve price stability. This does, however, allow for "the natural short-run variation in inflation over the cycle while preserving a clearly identifiable performance benchmark over time.” That is, it is okay for inflation to break out of the band if it is deemed to be temporary.
Two things to consider then.
– Inflation is low now, sure, headline is at 1.3 per cent year-on-year and core is around 2 per cent according to the Reserve Bank.
– Yet prices are not stable. Headline inflation was above 3 per cent only a year ago and core inflation was nearing the top of the band and accelerating sharply.
What will inflation be next year? Can it be said with any credibility that the risks of a sustained move below the 2 per cent target is high when:
– Inflation is not stable;
– inflation is already near (US) or above (UK and Europe) the official target or ‘desired’ range in many jurisdictions, and;
– Domestic growth is well above trend and at its fastest pace five years?
Only a fool would suggest this. Indeed most forecasters expect inflation to be within target over the next few years. With target and objectives met, it must be remembered that the game isn’t to keep cutting rates until inflation surges.
This is why we need to be extremely careful in how we respond to forecasts for lower global and domestic growth. The most recent manifestation is that the global economy is slowing sharply (again), that there is a substantial fiscal contraction underway and that the decline in the terms of trade will crunch growth – especially given the Australian dollar remains overvalued.
These forecasts have been with us for some time in one form or another – for years – and have been proven wrong time and again. Most of them are as false as they were in the past. Indeed policy makers must take into account the abysmal track record of these continually pessimistic forecasts - and forecasters. The fact is, the global economy is growing at a much faster pace than initially expected, notwithstanding recent slower outcomes. Similarly, the domestic economy is much stronger than the consensus and the Reserve Bank expected.
It is against this backdrop – goals of monetary policy met, the target is met – that the Reserve Bank must be alert to the risks of overshooting on the downside. They did this in 2009. But what would be the benefit? Growth is strong, inflation within the band – the goals of monetary policy have/are being met.
For me it is a simple risk/reward analysis. What is the reward to cutting rates now? Is growth going to be faster? More broad-based? Truth is that since the 125 basis points worth of cuts we’ve had already, home lending growth has slowed and confidence is lower. And it can’t be argued that policy was responding to these developments – they occurred after the fact, as a direct consequence of Reserve Bank’s action. House prices are recovering, sure, but that’s because construction is inadequate.
As for those risks? There are two. On the downside of course, the global economy may actually descend into another crisis. The probability is much reduced following recent ECB action, but it hasn’t been eliminated. Should the worst occur, we will need significant policy action. As it is though, cash at 3.5 per cent doesn’t leave much of a buffer. Indeed as rates approach zero, further cuts become largely ineffective. As a rough guide, I think it’s reasonable to assume that rates below 2 per cent would offer little in the way of additional relief from 2 per cent - or even 2.5 per cent. This means at best, the RBA has 150 basis points of effective policy stimulus. Not a lot.
Then of course we have the upside risks. These are substantial given economic growth both domestically and abroad has been consistently better than alarmists have claimed. Truth be told, there is a much higher probability that growth will be faster in 12 months time – with inflation higher. Should the Reserve Bank cut now they will be ill prepared to deal with this risk.
To ignore this – the objectives of policy, inflation, forecasts, strong growth and the risks of low rates – is, in my opinion, a manifest failure of the board’s duty of care and a breach of the agreement on monetary policy.
Why the RBA must not cut rates
The economy is still strong, we are at almost full employment and inflation is in the target range. To cut rates further today would be a manifest failure of the Reserve Bank's policy mandate.
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