From Westpac:
The Reserve Bank Board meets next week on October 4. There is little prospect of the Board deciding to move rates.
Since rates fell to 3% in December 2012 all six subsequent cuts have been in the February/May/August months. Those months, along with November, allow the RBA to respond to fresh information on inflation – printing quarterly usually around one week before the Board meeting. Those months also coincide with the quarterly Statement on Monetary Policy where the Bank releases revised forecasts for growth and inflation. Forecast changes at that time are usually used to justify the decisions either revealing significant revisions to growth or inflation forecasts. Based on this recent practice it would be extraordinary to see a policy change in October.
his meeting also marks the first time in the Chair for Governor Lowe.
I have written extensively about the need for the new Governor of the Reserve Bank to adjust the inflation target from 2-3% to 1-3% to reflect the reality of lower global inflation relative to the mid-1990’s when the target was originally successfully adopted. However, as noted at the time, I held out little hope that the new Governor would take my advice. Accordingly I was not surprised to see last week’s announcement that the target had been “confirmed” as 2-3%. However there has been a significant change from “on average over the cycle” to “over time”. The Governor also emphasised in his Statement to the House of Representatives last Thursday that “the main drafting change is to make the link between monetary policy and financial stability a little more direct”.
If we weigh those two changes together they go some way to achieving the objective that I was most concerned about. My concern was that the new Governor might, when confronted with an impossible task of lifting inflation to above 2.5% in order to “average” 2.5% over the cycle might unnecessarily impact asset markets. By using the vague term “over time” and linking policy directly to financial stability (read asset markets) he has allayed much of my concern on that issue. Markets are likely to eventually scale back prospects for further rate cuts given these developments.
We should not be surprised that this new Governor has chosen that approach. And we should certainly not dismiss this change in approach as “window dressing”.
Every great professional has a seminal piece of work that they can refer to as a “defining moment”.
I would argue that such a time came for a young economist, Philip Lowe, who had been seconded from the RBA to the Bank of International Settlements in Basel in the early 2000’s. In July 2002 he published a paper in the BIS Working Papers series.
He argued in his paper, that “financial imbalances can build up in a low inflation environment and that in some circumstances it is appropriate for policy to respond to contain imbalances…..while low and stable inflation promotes financial stability, it also increases the likelihood that excess demand pressures show up first in credit aggregates and asset prices, rather than in goods and services prices. Accordingly, in some situations, a monetary response to credit and asset markets may be appropriate to preserve both financial and monetary stability.” He further concluded that “greater co-operation between monetary and prudential authorities is important, not just in management of crises but also in preventing their emergence.” (Philip Lowe and Claudio Borio, BIS Working Papers, no. 114, July 2002).
Around that time the US housing market was beginning to “stir”. Chairman Greenspan had been cutting the Federal Funds Rate in the face of weak inflation. The Federal Funds Rate eventually bottomed out at 1% by June 2003 (a year after Lowe’s paper was published). When Greenspan eventually got around to lifting the Federal Funds Rate in June 2004 he moved at a leisurely and predictable 0.25% per meeting until June 2006 when the Federal Funds rate peaked at 5.25%. In Greenspan’s defence it has been argued that lifting the Federal Funds Rate from 1% to 5.25% over 2 years should have had more traction with the bond market – the US 10 year rate only increased from 4.6% to 5.2% over the period. This muted response has generally been attributed to Chinese purchases of US Treasuries over that period as China’s foreign reserves boomed.
Mortgage rates in the US are priced off long bond rates rather than the Federal funds rate so the response in the mortgage market to Greenspan’s policy was muted. However, if policy had been more preemptive, less orderly and predictable the traction with the bond market may have been much more effective.
Greenspan had clearly ignored the signals which had been emphasised in Lowe’s work – over the 4 years from end 2000 to end 2004 US house prices (Case Schiller Index) had lifted by 46% !
Greenspan’s response to critics who noted the build-up in pressures particularly in the US housing market was that his objective was to maintain low inflation and if there were any associated imbalances in other markets he could “clean up” in the aftermath of any asset market disturbance. Young Lowe clearly disagreed.
That paper, all those years ago, gives us a clear insight into the values of the new Governor. Arguably, if his warnings had been heeded by Chairman Greenspan back in 2002 (note that he only started rising rates in June 2004) the world may have avoided the Global Financial Crisis. We expect that these values will be an important driver of future policy. Lowe’s adjustment to the agreement with the Government to include financial stability has its origins in that paper all those years ago.
The balance between driving towards a higher inflation target and over stimulating asset markets (including housing) will take on a sharper edge than we have seen in the past. He is also likely to be open to the use of further macro prudential tools (as highlighted in that paper) should that be seen to be necessary.
I hope so but have sever doubts. Housing is all we have now. Lowe’s paper should have been listened to here well over a decade ago. Now, we’re all bubble managers.
Rates will go lower because the broken structure of the Australian economy will given Phil Lowe no choice.
