The RBA is in a real bind on interest rate movements: RP Data's Cameron Kusher

Following a raft of economic data that has come out recently I felt it was important to reflect on this data.  It is obvious that the Reserve Bank  is currently in a very tough predicament. While much of the data is proving to be quite negative and providing a clear case for interest rate cuts, every now and then other pieces of data highlight that perhaps things aren’t so bad.  Most notable of these data releases was the labour force data. Despite most economists expecting an increase to the unemployment rate, it remained at 5.2% and the participation rate actually increased.

As most people will know, official interest rates are currently sitting at 4.25%.  Now over the past 20 years, the cash rate has sat at an average of 5.15%, much higher than its current setting.  Although the cash rate is at above-average levels, standard variable mortgage rates are sitting at 7.4%, which is fairly close to the 20-year average level (7.35%).  In recent years the major banks have sought to de-couple mortgage rates from official interest rates.  As a result, we now have a situation where the official cash rate is almost 100 basis points below the long-term average however; mortgage rates are sitting at average levels.  As a result, the amount by which the RBA is able to influence repayments on our largest asset class (housing) has been lessened over recent years.

Looking at the RBA website, its official role is detailed at this link.  A lot of the data suggests that we are pretty close to full employment and that we still enjoy economic prosperity and welfare.  However, many would argue that the current high currency is providing instability. In its agreement with federal government the RBA is also charged with keeping inflation between 2% and 3% over the economic cycle.

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So looking at inflation and keeping in mind new data will be out later this month, headline inflation is currently recorded at an annual rate of 3%.  The RBA’s preferred measures of ‘underlying inflation’, the trimmed mean and weighted median are both well within the target range, recorded at 2.6%.  The most recent data available shows that headline inflation is at the top end of the target range (but it is falling) and underlying inflation is right around the middle of the band. 

Obviously the RBA is concerned about inflation and with good reason.  Glenn Stevens was made governor of the RBA in September 2006 and since December 2006, headline inflation has been recorded at an average of 3%, right at the top of the target band.  More concerning is the fact that the RBA’s preferred measures have been recorded at an average of 3.2% (trimmed mean) and 3.5% (weighted median).  Given this, it is no real wonder that the RBA decided not to cut interest rates this month. The RBA’s track record of hitting their inflation target has not been strong, and it wants to be as sure as possible before making any decision.

As I see it, it is fairly clear cut that another interest rate cut is required to help the economy, particularly if you take just a quick look at some of the recent negative economic data releases:

1. GDP – Australia’s economy continues to grow however, it is growing below the long-term trend
2. Property values – despite a stabilization over the first quarter of 2012, they are down -4.4% over the year
3. Consumer sentiment – the index continues to fall with pessimism outweighing optimism and the index is -10.2% lower than at the same time last year.
4. Business conditions – improving but still not particularly strong
5. Building approvals – continue to weaken and are -15.2% lower than they were at the same time last year
6. Housing finance data:
   1. When refinances are removed the value of finance commitments has risen by just 1.7% over the past year
   2. The number of non-refinance commitments remains at low levels and has increased by just 3.6% over the year
   3. Retail trade – remains quite sluggish having increased by just 2.0% over the past year
   4. Growth in demand for credit by the private sector remains benign:
      1. Total credit has risen by just 3.5% over the past year
      2. Housing credit has risen at an historic low rate of 5.3% over the year

Of course, times have changed in the Australian economy; consumers are saving again and credit isn’t as freely available as it used to be.  Although the Australian economy hasn’t entered into a recession it certainly seems that our mind set has changed and we are at least trying to be less reliant on borrowed money.  What that is likely to mean is that property values, building approvals, housing finance, retail trade and credit demand will grow at levels lower than those we have become accustomed to.  In saying this, just because the consumer mindset has changed it doesn’t mean we have to have a recession.

In my mind, we will see an interest rate cut next month as long as inflation is within the target range.  However, I don’t envy the RBA’s position, although a lot of the economic data looks bad they have been caught out before.  The significant growth in the mining sector is boosting the overall economy, the unfortunate thing being that most of us aren’t reaping these benefits.  Factors such as falling property values and lower levels of construction feed back in to consumers showing less inclination to spend which in-turn feeds back in to lower levels of consumer and business sentiment.  If we aren’t careful it could also lead to higher levels of unemployment and lower levels of economic growth or even a recession.

Let me know what you think. Was the RBA right to leave interest rates on hold and do you think it will do so again next month?

Cameron Kusher is senior research analyst at RP Data.