From Westpac’s Chief Economist, Bill Evans, comes the following assessment of the RBA’s tactics and policies, with Evans maintaining his call for further interest rate cuts:
The last week has seen some important “events” with regard to helping us assess the Reserve Bank’s current approach to policy.
Recall that in the November Statement on Monetary Policy the Bank lowered its growth forecast for 2014 from a trend 3% to a below trend 2.5%. The move was even more significant because its previous forecast envisaged growth in the first half of 2014 at 2.5% so the revision was all about the second half – revising the pace down from around 3.5% (comfortably above trend) to 2.5% (below trend).
With monetary policy assessed to act with a lag the forecast for growth “one year out” is most important since a below trend forecast over that period coupled with a 2.5% inflation forecast begs the question as to why the Bank is not easing policy immediately.
Of course that issue might be covered by the decision to maintain the growth forecast at 2.75%–4.25% in 2015 – a mid point of 3.5%, back to the expected above trend tempo that was previously envisaged for the second half of 2014. Of course, just as the lift from 2.5% to 3.5% through 2014 looked ambitious so does the new “lift” between 2014 H2 and 2015 look equally ambitious especially when the drag from the slowdown in mining investment is likely to be larger in 2015 than it will be in 2014 (we estimate –1ppt in growth from –0.7ppts in 2014).
The minutes to the last meeting at least recognised this issue by referring to: “it was prudent to hold the cash rate steady while continuing to gauge the effects, but not to close off the possibility of reducing it further should that be appropriate to support sustainable growth in economic activity”.
However this theme has now been referred to in the past three minutes and no action has been taken. For now, any urgency to address below trend growth with interest rates appears to have faded.
Instead there is clear emphasis on the exchange rate: “members noted that a lower level of the exchange rate would likely be needed to achieve balanced growth in the economy”; and “the Australian dollar, while below its level earlier in the year, remained uncomfortably high”.
So it was with great anticipation that we attended the Governor’s speech to the Australian Business Economists on November 22 which was titled, “The Australian Dollar- Thirty Years of Floating”. The anticipation was around getting an insight into the Bank’s assessment of the degree of overvaluation of the Australian dollar.
In that regard he noted, “It is not surprising that the exchange rate responds to changes in the terms of trade. It is nonetheless striking how close the empirical relationship has turned out to be”…. “very high terms of trade can be expected to lead to some loss of competitiveness, as noted above. Just how much of this would be expected depends, among other things, on how permanent the terms of trade rise is – but this episode has been very persistent so far”.
He concludes, “In the end it is not possible to come to a definitive assessment on the extent of currency misalignment at the moment, on the basis of standard metrics. Having said that my judgement is that the Australian dollar is currently above levels we would expect to see in the medium term”.
Unfortunately he does not commit to explaining whether his medium term assessment also includes a fall in the terms of trade.
He also quite appropriately refers to the impact on the exchange rate of “extraordinary monetary policy measures “in the US, Japan, and the euro zone. Arguably the effect of the unwinding of those measures may have already registered with the AUD. Note that the AUD fell by a net US 10¢ since FED tapering speculation emerged. Even though tapering has now been deferred, the AUD has remained around the level it reached shortly before the “non tapering” decision was announced on September 19 (Sydney time). The winding down of QE may already be largely priced into the AUD.
The commitment to lowering the dollar was strengthened in the speech by allocating an unusually long passage to intervention. Following the facts on the depth and liquidity of the AUD market, which appeared in an earlier part of the speech, that consideration seemed bold. “Global daily turnover runs at about $460 billion”. However he noted that the costs of intervention (negative carry) “would be a price worth paying, if it corrected a seriously misaligned exchange rate”. Thus far there is nothing in the paper to indicate that at current levels the Bank measures the currency to be “seriously misaligned”.
However he bravely continues: “We remain open ended on the issue. Our position has long been, and remains, that foreign exchange intervention can, judiciously used in the right circumstances, be effective and useful”.
Of course there is another “cost” which is not mentioned but dwarfs the “cost of carry”. That is the cost of failure. In such a deep and liquid market the Bank would now need to allocate a much larger arsenal, than in past interventions, to a successful intervention. Failure and the resulting mark to market loss on the newly acquired foreign exchange might prove extremely costly and potentially damaging to the government’s budget position – hardly a very attractive option for a central bank Governor when the “proof” of overvaluation of the currency is so difficult.
At one stage of the evening the Governor noted that interest rates are at a 50 year low even though growth and inflation are not at 50 year lows – that being because the exchange rate is so high. The clear implication is that if financial conditions are to be eased then a lower exchange rate is a preferable option.
Presumably, unease with prospective movements in house prices is the source of discomfort in using the interest rate lever any further. In earlier speeches the Governor has indicated that, to date, house prices have not moved out of line with incomes. The trajectory of house prices over coming months will be a key determinant as to whether the Bank believes that, in fact, it still does have some interest rate flexibility.
It is our view that the economy will evolve to indicate that further stimulus is required and interest rates are the appropriate instrument.
At present it appears that the Bank believes that the currency is the appropriate source of further financial easing. Given that it has not established that the AUD is necessarily markedly overvalued nor do we have any clear idea of the future path of the terms of trade or the policies of the major central banks it seems to me that interest rates offer a much more reliable option for further stimulus. Relying on lowering the currency by “jaw boning” or unconventional, and potentially risky, means seems less attractive especially when, by global standards, we have ample flexibility around interest rates.
One very significant test as to whether the economy does require further stimulus will come with the release of the Capex survey on November 29. Recall that this survey will have been “in the field” from late October, and therefore captures the first impact on business’ investment plans from the change of government. The August survey was particularly weak implying falls in mining; manufacturing; and a sharp downward revision to services investment.
In summary, the events of this week suggest that the Reserve Bank does acknowledge that the economy is in need of further stimulus. However its preferred policy approach is through the AUD. With uncertainty around whether it is indeed overvalued; the vagaries of policies in other central banks and the terms of trade; and the risks associated with intervention, it is my view that interest rates represent a much more certain and less risky option.
In time we expect that the Bank will come to a similar conclusion.
