Shadow RBA plants head in sand

From the RBA shadow board:

aggregate_february2015

Gyrations in global financial markets make Australia’s economic outlook very uncertain. The US economy is expanding, whereas other regions are flirting with recession. Domestic growth remains slightly below trend and headline inflation is below the official target band of 2-3%. The collapse in oil prices, the weakened Aussie dollar, and renewed uncertainty about the viability of the Eurozone add uncertainty to the global economic outlook. The CAMA RBA Shadow Board continues to recommend with confidence that the cash rate be held at its current level of 2.5%; the Board attaches a 68% probability to this being the appropriate policy setting. The confidence attached to a required rate cut equals 13%, while the confidence in a required rate hike has decreased to 19%.

According to the Australian Bureau of Statistics headline inflation has fallen to 1.7%, below the official target band of 2-3%. Much of this can be attributed to the fall in energy prices. The implications of low energy prices are unclear, as the drop in oil prices are the result of reduced demand as well as increased supply. In the medium-term the latter can be expected to be expansionary for the Australian economy. Core inflation, a measure of inflation that excludes volatile items such as energy and food, currently lies at 2.1% – within the official inflation target band – and is a better gauge for setting interest rates. It suggests that the drop in energy prices does not call for an immediate reduction in the cash rate.

After an extended period of low volatility, during which the Australian dollar hovered around the 85 US¢ mark, the currency has fallen another 8 US¢. If the dollar remains below 80 US¢ for some time, exports, in particular the tourism and education sectors, should expand appreciably and boost domestic production.

There remains some slack in the Australian labour market, with the Australian Bureau of Statistics’s most recent estimate of the unemployment rate being 6.1%. The labour force participation rate has picked up a little to 64.72%, while the change in employment, at around 40,000 per month, has been solid for the past two months. This suggests that rebalancing of the Australian economy, away from the resources sector, is reaching the labour market. However, wages growth remains muted and a growing share of employment is part-time.

The key headlines during the past weeks have centred on events in the financial markets. WTI crude oil has fallen from over US$100 a barrel to under US$ 45 a barrel in less than a year. Prices for other energy goods have fallen significantly also, as well as the price for iron ore. Global currency markets were in turmoil when the Swiss National Bank unexpectedly abandoned its cheap Swiss Franc policy and let the currency float freely. The outcome of the Greek election once again places question marks behind the viability of the Eurozone as Greece will need to borrow additional funds to service its existing debt. These uncertainties, along with promising signs coming from the US economy, have made global investors favour the US dollar. In trade-weighted terms the US dollar has appreciated approximately 10% during the past 6 months.

Consumer confidence remains subdued, with the Westpac Consumer Sentiment Index coming in at 93.2 this month (91.1 in the previous month, 98.47 six months ago). Capacity utilization remains virtually unchanged at 80.48% in December, while the manufacturing PMI has fallen considerably (from 50.08 in November to 46.91 in December). Conversely, the Services PMI jumped from 43.80 to 47.50 in December and the NAB monthly survey of business confidence remains weak at 2 (1 in November, 10 in August 2014). The Westpac-Melbourne Institute Leading Index of Economic Activity remained steady.

The outlook for the global economy remains uncertain though attention has shifted from geopolitical factors to financial factors. Europe is still looking weak – the European Central Bank recently announced a large-scale sovereign bond purchasing program to avoid deflation and boost growth in the Eurozone, and Germany is considering another Euro 20 billion bailout package for Greece. No further economic impulses are to expected from China, nor from Japan. The US economy is faring better but the growth continues to be highly unequal. A sustained upturn in the US economy needs to rely on significant wages growth for the middle class.

The consensus to keep the cash rate at its current level of 2.5% slipped two percentage points to 68%. The probability attached to a required rate cut increased noticeably to 13% (5% in December) while the probability of a required rate hike has fallen to 19% (25% in December).

The probabilities at longer horizons are as follows: 6 months out, the probability that the cash rate should remain at 2.5% rose ten percentage points, to 46%. The estimated need for an interest rate increase plummeted to 38% (56% in December), while the need for a decrease rose to 16%. A year out, the Shadow Board members’ confidence in a required cash rate increase is down ten percentage points to 61%, the need for a decrease edged up to 11% (10% in December).

The comment from Bob Gregory is a classic:

This is becoming very difficult because although the Australian economy is going down in my view I have no idea what will happen to world rates – except that the US and Europe will diverge – and no idea at this time as to how we will or should respond to this. The increased uncertainty about world interest rates has encouraged me to essentially sit tight on our interest rates until I get a clearer fix on what is happening. Obviously, not expecting a large change in either direction.

Here’s a hint, Bob, check out the bond market where rates are crashing worldwide.

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