Australia | Dec 17 2009
By Greg Peel
You’ve got to love central bank-speak. So subtle, yet so impactful. Traders like to spend time looking for a slight change in even one word in monetary policy statements.
It has been an eventful week in monetary policy. On Tuesday we had the minutes of the previous RBA monetary policy meeting, and last night we had a fresh monetary policy statement from the Fed. In between, we’ve had a speech from deputy RBA governor Ric Battellino that has caused quite a stir, and sent heads spinning.
Let’s just say that, for once, the Fed was pretty damned definitive about its monetary policy stance this time. But…
When it was announced Australia’s unemployment rate dropped again in November, all and sundry assumed February must see another RBA rate hike. Then when the minutes of the December RBA meeting were released (and bear in mind the meeting was held ahead of the unemployment numbers), acknowledgement by the RBA that the three rate rises to date had meant a “material” shift in policy and that the RBA was now “flexible” about further moves had opinions shifting back to “maybe no rate rise in February then”.
Then came the third quarter GDP, which was at 0.2% growth was lower than the 0.4% growth consensus forecast. This news reinforced belief that perhaps the RBA would wait at least until March. But all throughout these announcements, economists at banks and brokers across town remained adamant that 2010 would see a shift back towards a cash rate of 4.5%, and that a February rate rise was still pretty much a given.
Then along came Ric Battellino.
Battellino is recognised by economists as a “hawk”, meaning he leans towards monetary policy tightening (higher rates). The opposite is a “dove”, who leans towards easier policy (lower rates). As the BA Merrill Lynch economist team noted yesterday, Battellino is “known for well timed speeches that give monetary guidance outside the RBA Board meeting framework that usually have a shelf-life of well beyond the next news cycle”. In other words, Battellino is the tell-it-like-it-is man to counter RBA governor Glenn Stevens’ more subtle and considered approach. His words thus resonate longer before Stevens’ latest view is updated.
Or if you like, Battellino gives more away. Stevens obviously doesn’t mind too much, otherwise Ric would have been shown the door by now. But Merrills’ economists suggest that if this is another case of Battellino spilling more beans than Stevens on actual RBA thoughts, “today’s speech on bank funding costs by the deputy governor was rightly perceived by the financial markets as a signal that the RBA was ready to start going much slower on rate hikes”.
What Battellino said, in simple terms, is that bank funding costs have increased by an average 108 basis points above the RBA’s overnight cash rate since the world began to fall apart mid-2007. This is the extra “risk spread” required by the world to lend money to Australian banks in the new GFC regime. Hence, Australian banks have been forced to raise their actual lending rates by a similar margin above cash, with the business sector having “worn” most of it..
There are two implications here. Firstly, Battellino is defending those extra rate rises banks have recently made, even in mortgage rates (and even Westpac), as simple business reality. We can dismiss sensationalist political posturing or tabloid media attacks. Secondly, Battellino is suggesting that higher funding costs must also be taken into consideration by the RBA as a form of monetary policy tightening.
In other words, the wider the risk spread on bank funding, the less the RBA needs to raise its cash rate in order to tighten policy.
When the RBA made its first rate rise in October, all talk was of quietly moving the cash rate back to a “neutral” level. After realising Australia was not really going to suffer that much at all from the GFC, the “emergency” easy rate of 3% was no longer necessary, and in fact dangerous, as it might cause an asset bubble (particularly in housing). With each passing month, the RBA decided Australia’s economic growth rate would “return to trend” in 2010. On that basis, a “neutral” cash rate was sufficient, meaning one that was neither too “accommodative” (low) or too “restrictive” (high). Hence the RBA began in October to move its cash rate “gradually” back towards neutral.
One might argue as to exactly what the “neutral” cash rate might be, but taking an average of cash rates since 1993 (within which time the high has been 7.25% and the low 3.0%, both achieved in the last 18 months) as economists are wont to do, and we arrive at 5.50%. Therefore, the RBA has been hinting lately that rates are back on the move – slowly – towards 5.5%.
But now add in Battellino’s extra 100 basis points of independent tightening, and we might say that “neutral” rate is now 4.5%. But the cash rate is only 3.75%, so we’re still about 75bps short. Yet yesterday Battellino concluded “that the overall stance of monetary policy is now back in the normal range, though in the expansionary segment of that range”. Policy is “less accommodative, but accommodative nonetheless”.
This is exactly the part the popular press jumped on in this morning’s editions – the statement “monetary policy is back in the normal range”. This has been taken to mean policy is already back to normal given the extra 100bps of funding costs, and therefore we don’t really need another rate rise in a hurry.
Ah hah. But this is where the subtleties of central bank-speak come into play. “Normal” is not “neutral”.
Over to the Citigroup economists:
“The wording here is important, as Ric did not mention neutrality. This concept was discussed by the RBA governor Glenn Stevens following a speech last week in which he said that the neutral rate of interest may not necessarily be lower. Economic expansion and potential capacity issues could potentially see it higher.”
Confused? Okay – consider that the low mark in the cash rate of 3.0% was an “emergency” rate, probably a once-in-a-generation event, and thus not “normal”. Clearly it was also far from “neutral”. But under “normal” circumstances, outside GFCs, economies ebb and flow and occasionally need a bit of accommodative encouragement (lower rates) and occasionally a bit of restrictive cooling down (higher rates). This is the “normal” turn of events.
Now consider that taking the midpoint of a 15-year cash rate range, in this case 5.5%, is an overly simplistic way of considering what is the “neutral” point between accommodative and restrictive. Global circumstances change, and thus so should the “neutral” rate. In this case, and despite yesterday’s seemingly low GDP result, the RBA expects the Australian economy to return to trend growth in 2010 and then potentially surge thereafter from the ashes of the GFC, led by Chinese, and other emerging market, demand. What Citi is interpreting from Stevens’ words is that from 2011 and beyond, the “neutral” rate may be more like 6% or even higher.
The upshot? Battellino’s “normal” does not mean the same as Stevens’ “neutral” and thus we cannot say that rate rises are over for now.
ANZ economist Warren Hogan summed up the general feeling amongst his peers:
“Although the Deputy Governor has been known to have his ‘own views’ publicly, one would have to conclude that today’s speech contained a strong policy message for the broader community. And that message seems to be that a gradual move in interest rates back toward neutral does not entail a 25bp increase at every meeting until the cash rate is sitting somewhere between 5% and 6%”.
ANZ’s conclusion is that there will be a 25bp hike in each quarter of 2010 to take us back to 4.75% by year-end, but that rates will need to be higher over the next few years.
Westpac’s Bill Evans made particular note that Battellino singled out business borrowers as having copped the brunt of the 100 extra basis points of bank funding and not mortgage borrowers. (In obvious defence of his banks’ 45bps mortgage rate increase, Evans suggests bank funding costs are really 120bps higher, not 108bps). Yet it is the housing market the RBA is more worried about in terms of a potential bubble, so Evans suggests that extra 100bps is “overstating the ‘new neutral'”.
Westpac expects a cash rate of 4.25% by mid-2010 and 4.75% by year-end, in line with ANZ.
RBA Australia’s economists go one better, suggesting strong employment numbers for the month of December and stronger CPI inflation for the fourth quarter will mean 5% by end-2010 (with 6% expected for end-2011).
Which brings us to the question: Will we or won’t we see a 25bps rate rise in February? The popular press is tending to suggest we won’t.
Well let’s continue this straw poll. Citi agrees with RBS about Q4 CPI, and both the CPI and the December unemployment numbers are due out in January. Citi suggests the Q4 CPI will have to be lower than the trend is currently suggesting for the RBA not to raise in February.
The UBS economists state “we continue to see the RBA having a little more work to do early next year, before pausing”. They are targeting 4.25% “by the March quarter”, which implies 25bps hikes in both February and March.
And finally, Merrill Lynch’s economists suggest another hike to 4.0% in February before a pause in March. But they still see 4.5% by mid-2010 and 4.75% by end-2010, in line with peers.
So to conclude, don’t jump to conclusions about Battellino’s speech, assuming it clearly implies some mortgage relief early next year.