CS: RBA has lost it

Via the excellent Damien Boey at Credit Suisse:

Minutes from the RBA’s early October meeting were dovish. The Bank highlighted:

  1. Its easing bias.
  2. That rising house prices are not a constraint on policy easing right now.
  3. The low(er) exchange rate as an especially important channel for rate cuts to be transmitted to the broader economy.

One paragraph in particular caught our eye(s):

Members also considered the argument that some monetary stimulus should be kept in reserve to address any future negative shocks. However, that argument requires changes in interest rates to be the key driver of demand, rather than the level of interest rates, which experience has shown to be the more important determinant. Members concluded that the Board could reduce the likelihood of a negative shock leading to outcomes that materially undershot the Bank’s goals by strengthening the starting point for the economy.”

We struggle to understand and translate exactly what these sentences actually mean. But our best guess is as follows. The Bank’s view is that the level of interest rates inversely correlates with the rate of growth in GDP. Therefore, low interest rates set the scene for strong real GDP growth. Now, there is uncertainty as to whether further cuts from low levels will cause a meaningful acceleration in real GDP growth. Therefore, the ideal solution is to lift the starting point for real GDP growth now, so that even after a negative shock, the final growth rate does not look too bad.

We think that this thinking is riddled with contradictions. These notwithstanding, the Bank is clearly saying that it is more concerned with building a buffer in real GDP growth now, than building a buffer in interest rates. Indeed, it is so concerned with building a growth buffer – more growth today, that it is almost resigned to the view that there might not be much growth to be had tomorrow. This is an extraordinary turnaround in policy thinking. Over the past few years, Bank officials have told us how important long-term financial stability is. Now, they are saying that today is all that matters – “que sera sera” in the longer-term.

If our interpretation is correct, this is the most dovish statement that the RBA could make. Lower rates, and growth at any cost. Interestingly, officials did reiterate its macro-prudential framework in the minutes in its discussion of house prices – but in a very skewed way. Officials suggested that they are not worried about rising house prices just yet – but they will worry when there is accumulated evidence of a leverage build up. We all know that asset prices lead credit aggregates, and the RBA is waiting to see a clear (lagging) trend in credit growth. So in other words, the RBA is saying that it is willing to apply macro-prudential policy like it did before – after the fact, or when the “horse has bolted”.

For what it is worth, we think that the RBA is partly right in its thesis that the level of rates lines up with the rate of change in real GDP. It is not so much the absolute level of real interest rates that matters – nor strictly the rate of change. Rather, it is the de-trended level of real interest rates that matters. The trouble is that the trend is changing through time, as our concept of neutral changes. And the best, real-time proxy for the trend in real interest rates is simply the inflation-indexed 10-year bond yield (term risk premia distortions notwithstanding). For this reason, the slope of the real yield curve is a key input into our broader assessment of financial conditions. Right now, the curve is slightly upward sloping, consistent with reflation. There are other factors pointing in the same direction – undershooting in the AUD/USD relative to fundamentals (terms of trade, real interest rate differentials, relative currency scarcity), positive real wage growth, and an improving credit impulse (fiscal expansion, and terms of trade gains). Indeed, our proprietary financial conditions index (FCI) is pointing to rather easy policy settings, consistent with material re-acceleration in growth over the next year.

With all of this in mind, we think that the RBA is going to err on the side of over-stimulating the economy. So will the Federal government “push comes to shove”. All of this is very supportive of curve steepening in the fixed income (flat-to-higher long-term bond yields, lower short rates). It is also supportive of value investing within the equity market, especially in the domestic cyclical and financial spaces. For further discussion, please see our recent article “The case for curve steepening: part II” dated 10 October 2019.

Sometimes you have to look beyond your quanty models. The RBA said a lot of sensible stuff for the first time yesterday:

The Board’s discussions also focused on the ongoing strength in employment growth. The period of strong employment growth had not reduced spare capacity in the labour market significantly. Almost all of the strength in employment growth over the preceding three years had been matched by higher participation, so there had been little progress on reducing unemployment and underemployment. It was also possible that participation was rising partly in response to weak growth in incomes. Moreover, employment growth was forecast to slow over the period ahead.

Members also discussed the possibility that policy stimulus might be less effective than past experience suggests. They recognised that some transmission channels, such as a pick-up in borrowing or the effect on the home-building sector, may not be operating in the same way as in the past, and that the negative effect of low interest rates on the income and confidence of savers might be more significant. Notwithstanding this, transmission through the exchange rate channel was still considered likely to work effectively, and evidence suggested that the positive effects of lower interest rates on aggregate household cash flows via lower debt repayments was likely to support household spending, given that household interest payments exceed receipts by more than two to one.

Members also noted that the housing market and other asset prices might be overly inflated by lower interest rates. Members acknowledged that asset prices were part of the transmission mechanism of policy, including by encouraging home building. By themselves, higher asset prices were considered unlikely to present a risk to macroeconomic and financial stability. This assessment would need to be reviewed if rapidly increasing asset prices were accompanied by materially faster credit growth, weak lending standards and rising leverage. Although household debt was still considered high, members saw only a limited risk of excessive borrowing at the current juncture: household disposable income growth (and thus borrowing capacity) is weak; the memory of recent housing price falls is still fresh; and banks are still quite cautious in their appetite to lend. Nonetheless, members assessed that close monitoring of this risk was warranted.

Members concluded that these various factors did not outweigh the case for a further easing of monetary policy at the present meeting. Taking into account all the available information, including the reductions in interest rates since the middle of the year, the Board decided to lower the cash rate by a further 25 basis points. Members judged that lower interest rates would help reduce spare capacity in the economy by supporting employment and income growth and providing greater confidence that inflation would be consistent with the medium-term target. Members also noted the trend to lower interest rates globally and the effect this was having on the Australian economy and inflation outcomes.

The RBA is slowly recognising the structural changes wrought upon the economy by destructive population growth, without naming it:

  • income can’t grow as immigration creates its own supply and ravages work security;
  • dwelling construction has been dislocated by the defect crisis arising from breakneck approvals and foreign builders;
  • house price wealth effects are waning as household debt hits extremes and bear monitoring as the Government pours in more warm bodies, and
  • these are structural changes that mean interest rates need to be structurally lower if we are to generate inflation.

A rise in a leading financial conditions index is all well and good but it, too, is likely to misfire in these changed circumstances.

To my mind, the RBA is finally turning sane. It can’t rebuild an interest rate buffer in this economy. Indeed, it is still miles behind the curve in its easing efforts regarding inflation and growth. And dead ahead is an entirely predictable terms of trade crash that will make it all worse.

Preserving ammunition for a cyclical shock when a structural change is already demolishing everything in site makes no sense.

Houses and Holes

David Llewellyn-Smith is Chief Strategist at the MB Fund and MB Super. David is the founding publisher and editor of MacroBusiness and was the fouding publisher and global economy editor of The Diplomat, the Asia Pacific’s leading geo-politics and economics portal.

He is also a former gold trader and economic commentator at The Sydney Morning Herald, The Age, the ABC and Business Spectator. He is the co-author of The Great Crash of 2008 with Ross Garnaut and was the editor of the second Garnaut Climate Change Review.

Did you know the MB International Shares Fund has returned an average of 17.1% per annum and the Tactical Growth Fund an average of 10.4%? Register below to learn more:

Latest posts by Houses and Holes (see all)

Comments

  1. TailorTrashMEMBER

    “dwelling construction has been dislocated by the defect crisis arising from breakneck approvals and foreign builders;”

    And now the strayan economy has severe cracks in the basement ….perhaps we can we jack it up with some giant props ….I’m sure China could sell us some

    • For sure, they can. Indeed, what would pass for “giant” props here are viewed as tiny props in China…. the kind that fall out of cereal packets for kids to play with.

        • Exactly and what motivates this entity called peachy.Is it money in one form or another .I suspect so.Declare your interests otherwise shut up

        • I support Peachy taking off the mask and going full spruik. The despondent bear persona he / she adopted in the past always seemed a bit forced and fake. The new Peachy is a big improvement IMO.

        • …you guys!!!! ….o.O

          It’s just become much clearer in my mind, over time, hoe much of the adjustment will be forced onto an internal devaluation of the currency.

          “High” house prices doesn’t mean prices will fall. It doesn’t even mean that prices are “high”! It just means purchasing power is getting slaughtered all the time.

          There is actually no limit to this. Or at least none that leads to a situation where houses become affordable.

          In a sense it’s a tale as old as time – inflation rating everyone alive. Each day standards of living falling away a little more.

          (I must acknowledge the input of Pfh in helping me attain better clarity)

          • I responded to this yesterday.

            But here it is again, if it helps soothe your butthurt: The views I express are all my own. I don’t get any payment or benefit from my participation here…..apart from the psychic satisfaction I obtain from being so so right all the time.

            😘

          • 1 thing I agree with Peachy on is that your purchasing power is being totally and utterly destroyed by the RBA and it’s lower teh rates mandate. That means the same $1M today is not buying the same goods tomorrow. It’s just the way the game has been rigged which means if you own assets you’re ok, if you don’t you’re being punished and it’s a form of Government endorsed theft.

          • Cheers Peaches,

            I don’t know why you get such a hard time for what is the bleeding obvious.

            Only the hopelessly trusting would think that the privatisers of public money power would not ruthlessly use that power to preserve the power and position of those who already own assets.

            We are not talking about the 1%, the 10% or even the 20%.

            We are talking about the top 30-35% taking the bottom 65-70% for a ride and every day in every way they get better at it. Hoping they stuff it up is always an 18 months away kinda thing.

            The value of money is tied to nothing it is about all power and maintaining that power.

            Land ownership is the oldest game in town.

            Get it while it’s hot.

          • @gavin,
            “1 thing I agree with Peachy on is that your purchasing power is being totally and utterly destroyed by the RBA and it’s lower teh rates mandate. That means the same $1M today is not buying the same goods tomorrow. It’s just the way the game has been rigged which means if you own assets you’re ok, if you don’t you’re being punished and it’s a form of Government endorsed theft.”
            How was your purchasing power trending on that million looking back in the 80’s with the 18% interest rates?
            Fiat currency is inherently Government endorsed theft, low interest rates or high. It’s just easier to hide.

  2. Goldstandard1MEMBER

    I’m looking forward to what ACTUALLY breaks the back of house prices. My guess is unemployment and tighter credit via Australia loosing AAA rating. Those are the cards at the bottom of the house for me. Place your bets!

    • Unemployment and high interest rates were always going to be “it”.

      The tricky question is when. And whether the “when” is too far away for practical purposes.

  3. Goldstandard1MEMBER

    I love way you talk like an expert.
    You never know who’s nude until the tide goes out. I don’t think you own clothing.

  4. proofreadersMEMBER

    Having screwed savers and retail depositors in to the grave, the RBA happy clappies are now down to firing blanks?

    Even wholesale funders will want some return for chancing their money with our “unquestionably strong” banks?

  5. “dwelling construction has been dislocated by the defect crisis arising from breakneck approvals and foreign builders;” – I am sorry but you are wrong on this one. Are you going to blame foreigners for everything and anything now?
    First, there are just about as many domestic dodgy builders. I am 100% sure even if there was no single foreign builder here we would have caused just as many defects.
    Second, if Australian authorities do nothing about dodgy practices then both, domestic and foreign builders will start cutting corners. So why singling out only foreign builders?
    And I am against mass immigration in case I am labeled immigration shill.

    • The situation is really very simple.

      If the construction quality is difficult to ascertain then it does not pay for local builders to produce quality buildings because they are competing with low quality dodgy foreign builders who can cut corners and lower costs/increase profits. Up to recently it has basically been a race to the bottom due to strong competition by dodgy builders and low quality foreign labour, with the biggest profits being made by the initial owners of the land on which buildings are constructed.

      I suppose its possible that now that there is general awareness of the issues, that the few remaining builders who are perceived to build structures with few defects will get some sort of support by the market above the dodgy ones.