Should the RBA cut rates if inflation drops?
Just when it seemed the Reserve Bank of Australia was happy with its current interest rates settings, this venerable institution has appeared to pivot once more. Indeed, there’s now a non-negligible risk of an interest rate cut at the November (Melbourne Cup) policy meeting, and the bias on rates heading into 2017 is firmly to the downside.
And for the first time in a long time, I don’t agree with the RBA’s policy inclination. To my mind, there are now strong reasons to leave local interest rates on hold for the foreseeable future.
A quick recap. Having already cut official interest rates twice this year, the RBA’s rhetoric had shifted to a more neutral tone in recent months. That’s seemed to reflect firmer business conditions overall, rising commodity prices and a declining trend in the unemployment rate.
Indeed, in his statement following the October RBA Board meeting, the newly installed Governor, Philip Lowe, pointedly excluded reference to the upcoming September quarter consumer price index report as having a potential bearing on the November interest rate decision – a departure from references to the March and June quarter CPI releases in the policy meetings prior to the rate cuts in May and August.
To RBA watchers such as myself, that seemed to suggest the RBA was not “sweating” over the next CPI release, and so was unlikely to cut rate in November even if inflation surprised on the downside.
So far so good. But in the minutes to the October policy meeting released this week, that loaded phrase was back again. Notably, the minutes indicated “[Board] [m]embers noted that data on CPI inflation for the September quarter and an update of the forecasts would be available at the next meeting. This would provide an opportunity to consider the economic outlook, assess the effects of previous reductions in the cash rate and review conditions in the labour and housing markets.”
Just to emphasise the point, Governor Lowe in a speech this week noted the RBA was on guard not to allow inflation expectations to drift much lower, and in that light he observed “one of the key influences on inflation expectations is the actual outcomes for inflation. We will get an important update next week, with the release of the September quarter CPI.”
To my mind, all this is a clear indication that the RBA stands ready to cut rates again in November if next week’s CPI result again surprised on the downside.
What constitutes a downside surprise? To my mind, that would require a drop in annual underlying inflation from the 1.5% rate seen in the past two quarters, to at least 1.25%.
Of course, all this begs the question: should the RBA cut rates if inflation drops lower? In cutting rates, the RBA’s aims is to counter any further downward pressure on inflation expectations by encouraging – and importantly in the near-term, being seen to encourage – even faster economic growth and inflation over the medium-term.
What’s more, while the RBA is mindful of possible bubble risks in the housing market from cutting rates further, it appears to be confident that these risks are contained – due to the fact that housing price strength is not nationwide, and rising housing supply should lead to a self-correcting market adjustment eventually.
I have several problems with this approach. First, the economy is healthier than it was earlier this year, even if some measure of labour market slack remains elevated. By continuing to react so strongly to near-term downside inflation surprises, moreover, the RBA risks creating the perception that it is less flexible and less focused on “medium-term’ inflation targets than it suggests. Critically, it’s then at risk of losing credibility to the extent it’s not able to arrest the decline in inflation anytime soon, particularly, as even the RBA acknowledges, it is at least partly structural in nature.
In regards to financial stability risks, the RBA also seems overly focused on the housing market – ignoring that equity valuations (particularly for defensive yielding stocks) are also overvalued. More broadly, low interest rates are creating financial distortions across the economy, not just housing.
Last but not least, the lower rates go, the less scope the RBA leaves itself to react should the economy actually take a serious turn for the worse.
I think it’s time to start saving ammunition.
Published: Wednesday, October 19, 2016
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