Economics | Apr 29 2014
– RBA cash rate at historical low
– Next move is up
– Neutral setting now lower than previously
– Fewer rate hikes required
By Greg Peel
The Reserve Bank of Australia’s mandate, notes Commonwealth Bank, is to maintain price stability, full employment and the economic prosperity and welfare of the Australian people. In simple terms, it is the RBA’s job to promote steady economic growth while keeping inflation under control, independently of political interference, through the manipulation of overnight borrowing costs.
Before the Hawke-Keating governments began to free up Australian capital and money markets from 1983, the Aussie dollar and the cash rate were fixed by the government. There was no consideration given to inflation, which spiked to double-digits during the two oil shocks of the 1970s, occurring during the Whitlam and Fraser governments. In the 1980s the RBA became an independent organ and as such monetary policy became not a plaything of the government, alongside fiscal policy, but a non-political counterweight to fiscal policy. Taking a lead from then US Federal Reserve chairman Paul Volcker, global central banks began to use the cash rate to control inflation as well as economic growth (the two are inexorably linked).
Once the Aussie dollar finally settled post-float, it didn’t move much for some time. Only when the rest of the world began to take interest in the Australian economy did the currency start to fluctuate more wildly, and from that point the RBA was forced to pay attention. And it has only been since the GFC that the RBA has begun to pay closer attention to asset price (property, stock market) inflation as well as price (CPI) inflation.
It is thus the RBA’s mandate to juggle economic growth, inflation (price and asset), the currency, and fiscal policy in setting monetary policy in Australia’s best interests. Drilling down, this also means paying attention to the terms of trade, savings, productivity, credit growth and lending margins, notes CBA.
All of these factors can only be controlled by one lever – the overnight cash rate. If money is too expensive the economy will stagnate. If money is too cheap inflation will be fuelled. The aim is for monetary policy, via cash rate setting, to be either “accommodative” when the economy needs help or “restrictive” when it needs cooling down, all with the goal of reaching a “neutral” setting, at which the economy is in comfortable equilibrium.
A bit like the proverbial balancing on a beach ball in a swimming pool.
In order to be either accommodative or restrictive, the RBA must know what the “neutral” level of the cash rate is, or at least have a reasonable idea. Yet such a level is not set in stone, and is indeed beholden to all the above-mentioned factors. In other words, today’s neutral level may be different to an earlier neutral level and different again to a future neutral level.
(One might also suggest an element of Heisenberg here: the policy impact of trying to reach neutral will actually move the neutral point.)
So what is “neutral” at the moment? And why is it important to know?
It is important to know because if the RBA decides it’s time to start raising interest rates again, after having cut from 7.25% in 2008 to 2.50% in 2013, the neutral point will be where the RBA hopes to settle again. The higher that point is, the higher the cost of mortgages in particular and all loans in general (and on the other hand, the higher bank deposit rates will be).
The reforms of the 1980s led to greater productivity in Australia, and thus real income growth, notes CBA. Productivity then peaked and began to decline in the new century, but rather than real incomes also declining, which would prompt rate cuts, they continued to grow thanks to rising commodity prices and the mining boom, thus forcing higher interest rates. With the growth in mining now over, productivity remains low.
The RBA has cut its cash rate to an historically low 2.5% to counter the now falling terms of trade, the high currency, and the transition away from reliance on mining growth. It will take some time for productivity growth to be restored, hence the neutral cash rate will be lower than it was a decade ago, suggests CBA.
As the Australian economy boomed thanks to mining, Australians went on a spending spree. This required higher interest rates to offset inflation, but it all ended in tears in 2008. While there has been some modest recovery in spending, Australians have learnt a lesson and, at least for the time being, have become more frugal and more appreciative of debt reduction and savings. Thus the neutral cash rate will be lower than pre-GFC.
The Howard government enjoyed the benefits of the mining boom and subsequent budget surplus, and responded with a loose fiscal policy (tax cuts, baby bonuses etc). The Rudd (-Gillard-Rudd) government copped the GFC and a subsequent budget deficit, forcing tighter fiscal policy aimed at returning the budget to surplus. The Abbot government is threatening to take such tightening to a new level with its first federal budget. Tighter fiscal policy reduces the need for monetary policy counter-balance. Thus the neutral cash rate will be lower than at the time of the Howard government.
Before the GFC, global interest rates were low, allowing Australian banks to acquire cheap offshore funding and subsequently hand out loans like chocolates. Since the GFC, bank funding costs have risen and both the banks and their lenders have tightened their lending practices. If money is already tight, the RBA does not need to make it any more expensive. Thus the neutral cash rate will be lower than before the GFC.
When the Aussie dollar largely settled post-float, as noted above, it did so at around US70c, which was thus considered about “normal”. The new century has brought about a lot of currency volatility, but suffice to say when the developed world crashed in 2008 and emerging markets (read: China) stepped up to the plate thereafter, the Aussie became a “safe” proxy for the replication of emerging market investment. Hence the Aussie shot past parity and all but killed off the Australian non-mining economy. Economists now suggest that the change is structural such that once the Aussie settles again, it will do so at a new “normal” of more like US88c. If the exchange rate is structurally higher, the neutral cash rate needs to be lower.
Put all these factors together and the result is a lower neutral cash rate, and thus interest rate “goal” for the RBA.
In 2004, the RBA suggested that the “zone of neutrality” for the cash rate was 5.25-6.25%. CBA believes that today, that zone has fallen to 3.00-4.00%, suggesting a “neutral” cash rate of 3.5%.
Thus if the central bank feels the need to start raising rates again given an improving economy and growing inflation threat, the initial target will only be 1% (one percentage point) higher than where it is now. Only if the Australian economy threatens to boom again, and at the moment we’re just hoping it won’t contract too far as result of the end of mining growth, will the RBA be forced to lift its cash rate higher.
CBA is forecasting the first RBA cash rate rise in November this year, with the 3.5% “neutral” level being reached in the second half of next year.
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