Thinking about Australian Monetary Policy

Another big week coming up, with the RBA’s first Board meeting of the year tomorrow, the much-awaited retail sales reading for December on Thursday, the RBA’s February Statement of Monetary Policy on Friday and US non-farm payrolls data for January on Friday night.

Australian semi-government markets will also be reacting to the very surprising Queensland state election result, which saw: (i) the Labor Party win a majority of seats with a massive swing against the Liberal National Party after only three years (the LNP previously held 78 out of 89 seats); (ii) the Premier lose his own seat (this was expected); and (iii) the likelihood of a Labor minority government, with the balance of power likely to be held by the two members of Bob Katter’s KAP Party and one independent. QTC spreads have widened as the markets had expected the LNP to be returned enabling it to pursue its large privatisation agenda, which included using a significant amount of the proceeds of privatisation for debt retirement to support the return of a AAA credit rating to Queensland. The markets are likely to anticipate this to occur more gradually now.

Quickly reviewing last week, the main talking point was an article by The Telegraph’s RBA watcher Terry McCrann, which predicted that the Bank was likely to cut interest rates at its February meeting and was certain to change its “period of stability” language surrounding the outlook for the cash rate. This article has been followed up today by an equally authoritative missive from SMH/Age economics journalist Peter Martin, similarly suggesting the Bank will cut interest rates tomorrow. Historically, it has not been a good bet to take the opposite side of, when these two journalists’ views are aligned, though each does leave some wriggle room that the Bank may merely evolve its words tomorrow, ahead of an interest rate reduction in March. Typically, when the Bank decides a change in policy is required, it tends to move earlier than the market expects.

As we go to print, the market has now fully priced a 25bps rate cut by March, and has now priced a second rate cut by May. 61 bps of rate cuts are priced over the next 12 months (meaning around a 50 percent chance of a third 25bps reduction) and the cash rate in December 2019 (five years away) is still priced below the current cash rate of 2.5%!

We obviously don’t have to wait long to see whether the RBA did steer McCrann (and Martin) though one suspects an actual rate reduction could provoke some uncomfortable questions for the Governor at his upcoming Parliamentary Testimony, not to mention perhaps by some of the external members of the Bank’s board (along with a chorus of outrage from “wounded” market economists). The main logic against a move tomorrow, is the need – absent a crisis – for the Bank to evolve its language from its period of stability guidance maintained at the December meeting. Again, history suggests, that the Bank often surprises markets by acting sooner than expected, once it has decided a move is required.

So why move?

Peter Martin’s article seems to provide the best explanation about why the Bank seems to have changed its view. Martin argues that growth annualised at 1.6% over the past six months and there is little evidence of a significant pick-up in growth in prospect. This is resulting in the unemployment rate continuing to trend higher at around 0.1% per quarter. With inflation in no way a constraint on its actions at the present time, there seems to be no good argument against a further modest easing designed to support a quicker return to trend growth. In terms of the positive narrative that the Governor hinted at in a major interview before Christmas, this could well involve the combination of lower interest rates, substantially lower oil prices and the lower $A all providing considerable support to the Australian economy in the period ahead.

These themes are incorporated in NAB’s forecasts of moderately softer GDP growth in the near term (and hence a prior forecast of a rate cut in March) and stronger GDP growth in the medium term, with a second rate cut in August if the $A stayed high and growth did not accelerate. We now must question if the Bank is likely to move rates twice in relatively quick succession (as is most often its modus operandi) or whether this move is more in the unusual camp of being a modest fine tune, to complement the support from lower oil prices and the lower $A. We will consider the implications for our near term interest rate forecasts after the Statement of Monetary Policy on Friday, unless tomorrow’s Interest Rate Decision leads us to some very strong conclusions.

The week ahead

Apart from the close focus on RBA matters, there are also the regular monthly building approvals and retail sales data out this week. The market is looking for a 5% fall in building approvals (after two fairly strong monthly outcomes driven by the volatile apartment component) – even if a sharper fall resulted, the broad trend is likely to remain for strong apartment approvals and a relatively flat trend for freestanding houses, which net will support GDP growth. There is also likely to be keen interest in December retail sales data (both the nominal monthly data and quarterly real data, the latter the first significant indicator of Q4 real GDP to be released in early March). The anecdotes of Christmas spending were somewhat mixed – some businesses reported strong sales, others commenced sales before Christmas, while generally most recorded strong post-Christmas sales. The market is looking for a 0.3% m/m increase in December, which if realised would represent reasonable growth in the context of relatively strong October and November outcomes. This may further confuse the issue of an RBA rate cut, as for the most part, the domestic data has improved since the December board meeting. While this is the case, the argument being signalled in the press seems more about trying to achieve a quicker return to trend growth than the current forecast track suggests.

The final major event of the week is the monthly US non-farm payrolls report on Friday night. Market expectations are for a 235K increase in payrolls (another solid result) and an unchanged unemployment rate of 5.6%. The Fed’s FOMC statement of last week made clear that the path of US interest rates will be influenced by the progress being made toward the Fed’s joint mandates on inflation and growth, of which the labour indicators remain a key variable on both fronts. For now, even the suggestion last week that rate rises might start later, even though the Fed also suggested the timing could be advanced, was enough to see markets push back the pricing of the commencement of rate hikes. It continues to be the case that the markets seem more fearful of the near-term impact on inflation and the threat of deflation from sharply lower oil prices and weak growth in Europe and China than the strengthening in US growth and the significant boost to growth that will likely occur further in the future on account of much lower oil prices.

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