Will the RBA field an inflation curve ball?

Recent bank funding developments will make the Reserve Bank's rates decision more complex than usual if inflation falls in the top half of its target band.

Today's fourth quarter inflation data is typically a key milestone for Australian savers and borrowers focused on the future course of interest rates. Yet recent ructions in credit markets make the RBA’s decision-making process vastly more complex.

On the one hand, the RBA may throw caution to the wind and cut rates further and faster in order to have its desired effect. Alternatively, Australia’s central bank could conclude that its two cuts in November and December, which have been passed on by the banks, have supplied sufficient relief for the time being, and it can wait to gather better information. There is, after all, something to be said for stability. And there is little doubt that a rate cut that was not passed on by the banks could prove damaging and destabilising to community confidence.

But more on these nuances later. I want to begin by dealing with today’s data. The first chart below shows the path of core inflation in Australia since the middle of 2010, using the RBA’s published estimates. What you can see is that for five consecutive quarters core inflation was heading in one direction. The RBA ignored the two very high core inflation prints over the first half of 2011 (having pre-emptively raised rates in November 2010), and then cut rates twice in November and December, partly on the basis of the very low 0.3 per cent result in the third quarter.

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The RBA targets keeping core inflation between two and three per cent per annum ‘over the cycle’. Since Glenn Stevens was appointed governor in September 2006, quarterly core inflation has, based on the RBA’s data, averaged 0.8 per cent, or circa 3.2 per cent per annum. Any credible judge would concede that the RBA would be uncomfortable with this track record.

Most analysts think the RBA will cut rates in February if the average of the two core inflation numbers prints at or below 0.6 per cent today. Assuming no further revisions to the first three quarters of 2011, which is a critical rider, a 0.6 per cent result would mean annual core inflation is sitting around 2.5 per cent.

Ordinarily, the RBA would have to see core inflation falling towards, or below, the lower bound of its target band to justify cutting rates into stimulatory territory. If the core number comes out at, say, 0.5 per cent or 0.6 per cent, the RBA can argue that the six monthly pace of inflation is in the lower half of its band, and, further, that it is forecasting weak outcomes over 2012 and 2013.

Since Treasury estimates that the ‘natural rate’ of unemployment is around 5 per cent, and the latest ABS estimate is 5.2 per cent, which is around where it has been for the last 12 months, it is not necessarily the case that the labour market provides the RBA with the smoking gun it needs.

As the two question marks in the chart above highlight, the curve ball for the RBA will be if the third-quarter inflation numbers revise up materially, which is not something it would want to see, and the fourth quarter prints at 0.7 per cent or higher. This would both put core inflation in the top half of the RBA’s target band, and perhaps more worryingly, suggest that the low third quarter result was an anomaly that did not supply grounds for subsequent rate cuts.

No economists are forecasting core inflation greater than 0.7 per cent today, so this would be a big surprise. Indeed, almost all economists believe that the risks are skewed to the downside, with the possibility of a very low, say, sub 0.3 per cent outcome.

One issue is that the quarterly standard deviation in core inflation since 2000 has averaged about 0.2 percentage points. It is, as a consequence, plausible that we get a result that is well below, or well above, the ‘consensus view’.

As someone with a substantial home loan, I would instinctively like to see mortgage rates fall further. Let’s nevertheless suppose that it evolves into a line-ball decision for the central bank. There are some additional wrinkles that make this situation especially challenging.

The first relates to financial market stresses. When the RBA cut rates in November, it argued via its media voicepieces that this was to be a once-off, technical adjustment to the cash rate to get it back to ‘neutral’. It pointed to the very low third-quarter inflation data as justification for this striking change in its position.

When the RBA then resolved to follow this cut up with another in December, it claimed that this was both a 50:50 call, and, further, not warranted by domestic economic conditions, which it stated were cruising along "at trend”. Its main focus was Europe, and the need to provide the financial system with insurance against adverse outcomes over the New Year period, especially since it was not planning on holding a board meeting in January.

One of the real-time measures of Australian financial market stress that the RBA says it watches closely is the ‘ITraxx credit default swap index’. Simply put, this gives an indication of investors’ daily estimates of the likelihood of Australian banks and companies defaulting on their loans. My next chart illustrates the changes in the ITraxx index since the RBA’s November board meeting.

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The good news is that the index has plummeted 17 per cent since December 6 (when the RBA last met), and is 12 per cent below its level at the time of the November meeting.

From a pure financial stability perspective, the RBA’s worst fears have not borne out. The eurozone has not collapsed, and the cost of government debt for most European nations has recently declined, given the success of the ECB’s long-term funding operations. As a final helpful point, the run of data out of big trading partners, like China, India and the US, has been much better than most forecasters expected.

There is, however, a flip-side to this slippery subject. While the credit default index has fallen strikingly, the New Year has brought with it a dislocation in Australian bank funding markets.

Whereas the major banks were previously raising five year, AA- rated senior, unsecured funding at around 1.5 percentage points above the benchmark swap rate, that has now risen closer to two percentage points. This is primarily because of the introduction of covered bonds, which have forced a repricing of the cost of all Australian corporate debt in the last week or two.

In contrast to other bank debts, covered bonds are ‘secured’ (as opposed to ‘unsecured’), and rated AAA rather than AA- (in the case of the four majors). They are, therefore, far safer than anything the banks have issued in the past, with the exception of securitised home loans (known as ‘residential mortgage-backed securities’ or RMBS, which also attract a coveted AAA rating).

Covered bonds have several advantages over RMBS, including: (1) they give investors recourse to both the bank and the assets (whereas RMBS only offers recourse to the assets); (2) the banks ‘overcollateralise’ the bonds, which means investors are given security over assets worth more than the value of their capital commitment; and (3) investors can compel the banks to replace impaired assets with good ones (whereas in an RMBS issue you are stuck with the assets you get).

The problem for the banks is that even with all these advantages, AAA-rated covered bonds are pricing at about 1.7 percentage points over the benchmark swap rate, which means that everything else – which has lower ratings and higher risk – must price higher again. So we have seen, and could continue to see, a secular increase in the cost of corporate debt since the introduction of CBA’s covered bond into the domestic market last week.

The biggest casualties of this new dynamic are the non-major banks, which will not issue covered bonds because they are too expensive to do so. The short explanation as to why is that the non-major banks start with much lower credit ratings than their bigger cousins (because the latter are regarded as ‘too big to fail’), and in order to lift one of their covered bonds to a AAA rating, they would have to provide substantially more security (ie, pledge more assets). In the words of one smaller bank CFO, it is simply ‘non-economic’ for them to do so.

The bad news is that the cost of all the non-majors’ unsecured debt is now soaring, because it is regarded as so much riskier than the majors’ covered bonds. This will likely force many smaller banks to boost their deposit rates and focus on raising funds in the retail market, which is not a bad outcome for savers.

This is but a simple sketch of what is going on in bank funding land. It means that if the banks want to preserve their historic net interest margins, they would currently struggle to pass on a standard RBA rate cut of 0.25 percentage points. That in turn creates uncertainty for the RBA.

How much should they cut by if they want to do so, and how much community angst will this process create if they cut by, say, two standard moves (or 0.50 percentage points) and the banks only pass on one? Does a double rate cut send confusing signals to Australians about the prospects for the local economy (ie, exacerbating the doom and gloom peddled by popular media)? And should monetary policy be used as tool to support bank margins, or are there more surgical solutions (such as public insurance)?

This is also complex for the banks, since the dislocation created by the advent of covered bonds creates extreme uncertainty for the major and, particularly, non-major banks as to what their ‘steady-state’ cost of funds will ultimately be. The bottom line is that nobody knows.

If core inflation settles at around the mid-point of the RBA’s target band, and the European imbroglio looks to be sorting itself out, there is a case for the RBA remaining on the sidelines until it gets better information on the effectiveness of its own policy. If, on the other hand, core inflation surprises on the downside, we should get more rate relief one way or another, which would be a welcome boon for borrowers and the housing market.

The ramifications of a high fourth quarter inflation number, and upward revisions to the low third quarter print, are possibly quite calamitous for our independent central bank.

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