Reserve Bank : A Rate cut could wake ugly beast
Those pressuring the Reserve Bank for more rate cuts should be aware of the risks.
Mortgage holders are doing pretty well out of low interest rates, paying less than historical averages to service their debts.
That’s exactly what the Reserve Bank wants to see, and why it continues to set its target cash rate at 2.0 per cent.
That rate is the main stimulatory factor holding up the domestic economy at present – some of the extra dollars in mortgage holders’ accounts are used to pay down their debts, but the rest is free to splurge on retail therapy, dining out or generally living it up.
It’s not the only thing kicking the economy along, however. The change of prime minister last September has lifted consumer and business confidence a little, and the super-low oil price is giving consumers more change when they fill up with petrol.
Those latter two boosts to the economy are fortunate, but not something policy-makers can pull out of a hat at will.
Interest rates, though, can be changed by the Reserve Bank based on its reading of the economy.
And given the uncertainty facing the Australian economy at present, the RBA is continually under pressure from the real estate and housing lobbies, and bearish economists more generally, to cut even lower than 2.0 per cent.
Is that a good idea? Well householders struggling to make ends meet would probably think so. Another 25 basis point cut, to 1.75 per cent, would save an average mortgage holder around $90 a month.
So why hasn’t the RBA pulled the trigger already? The economy is clearly performing below its full capacity, with the unemployment rate still too high (5.8 per cent), GDP growth is below trend, and inflation safely towards the lower end of the RBA’s target band of 2 to 3 per cent.
A cut too far?
Nonetheless, Reserve Bank governor Glenn Stevens and his fellow board members are sitting on their hands for good reason. They are watching a number of indicators that could help them decide to cut or, in the more distant future, raise rates.
One of those indicators was thrown into sharp relief this week, when the TDI/Melbourne-Institute inflation gauge figures were published.
According to the Australian Bureau of Statistics, inflation is running at 1.7 per cent. That’s below the RBA target band, and one of the main reasons for the pressure on the bank to cut again.
But in economics, figures ain’t figures. Many of the measurements taken by the ABS, or the TDI/Melbourne-Institute for that matter, contain three types of errors.
The first is statistical error – that just means that if you sample a hundred supermarkets for the price of food, you might only get a 95 per cent accurate reading on what the other couple of thousand supermarkets around the country charge.
The second source of error is natural variability. For example, retail spending figures spike upwards at Christmas and go slack in the autumn. To discern patterns in this volatile data set, therefore, economists give us a seasonally adjusted figure. And even that figure is pretty volatile, so it is smoothed out again using the ‘Henderson moving average’ to give us ‘trend’ figures.
The third type of error is smoothed by ‘revision’. As more date comes to hand, it’s often possible to improve the provisional numbers available at the earlier reporting date.
What’s really going on with inflation?
With all of that in mind, you can start to take various inflation figures with a pinch of salt.
The ABS says inflation is 1.7 per cent (well below the band), but when volatile items are excluded (particularly petrol at present), the ‘trimmed mean’ figure is 2.1 per cent.
Then again, the TDI/Melbourne Institute puts the headline figure at 2.3 per cent for the 12 months to January (2.0 per cent trimmed mean). And when that figure is delved into again, we find that ‘tradables’ inflation – the price of things which are bought and sold internationally, such as electronics goods – is 0.6 per cent month-on-month or 3 per cent year-on-year.
Annette Beacher, Asia-Pacific macro strategist at TD Securities, said of the data: “Tradable inflation was very strong, that’s a big jump forward for a monthly number. It could be one of many signs that we are seeing imported inflation from a lower currency. If we are really seeing tradable inflation pick up, it would be more of a discussion for the Reserve Bank.”
Yep. And that discussion is no doubt already taking place, and is one of the pillars holding the cash rate from falling below 2 per cent.
That’s because if the RBA loosens rates further, money supply will increase via increased borrowing – mostly in the mortgage market.
At the same time, we know that the dollar has fallen 35 per cent since its 2011 peak, which will inevitably lead to higher prices for imported goods.
On current settings, higher priced imports will push the overall inflation rate higher within the 2 to 3 per cent band, but with luck will not lead to excessive inflation.
But if money supply was increased further via a rate cut, we could see too many dollars chasing imported goods that are already rising in price – that’s a recipe for inflation, even while an ‘output gap’ persists at home.
In the 1970s, the phenomenon of stagnant growth at the same time as rampant inflation became known as ‘stagflation’.
That’s not where Australia is headed, but the threat of ‘stagflation-lite’ must surely be keeping Glenn Stevens up at night, and is something for those calling for ever-lower rates to keep in mind.