Should the RBA bail out financial markets?: Christopher Joye
In the Q+A after his speech last Friday night the RBA governor Glenn Stevens claimed that central bankers are spending a lot of time these days “nowcasting”. That is, trying to figure out exactly how the economy is tracking in the present tense.
In rationalising this allocation of time, he made a statement of the obvious: unless you know what your starting point is today, it is nigh on impossible to make a credible forecast of where you will be tomorrow.
A more impolite interpretation might be that since the RBA has little faith in its own forecasting prowess – which is why it discarded its November 2010 experiment with ‘pre-emptive monetary policy’ – its next best option is to concentrate its energies on determining how the economy is tracking right now.
That is not as easy as it seems. Even carefully collated data, such as core inflation, is subject to material errors. As regular readers will know, the RBA, media and financial markets were grossly misled by a major downward revision to the second quarter core inflation print.
This had serious ramifications for the RBA’s approach to monetary policy, which it shifted away from a tightening bias. Yet a second revision to these same numbers (which was, therefore, the third time the ABS had attempted to calculate them) increased the Q2 core inflation estimate back up to unacceptably high levels that would normally warrant policy tightening.
Unfortunately, that’s the nature of the imperfect informational beast that the RBA has to grapple with.
Today we get a batch of new data that will shed further light on how
We also have RP Data-Rismark’s October house price index results, which will show that capital city dwelling prices are down 2.8% in raw terms (4% seasonally adjusted) over the first 10 months of 2011. Given that the dollar value of rents is rising at nearly a 5% per annum rate, this modest 3% to 4% correction in housing costs is no big deal.
Importantly, our house price data precedes the RBA’s crucial November rate cut, which, in concert with record yield curve inversion, has forced home loan rates to plummet to as low at 5.99%.
As a quick aside on the housing market, the ABS tells us that seasonally adjusted housing finance approvals to people buying established homes have increased every month over the last seven months to the end of September.
We also know that consumer confidence in November rose to above-average levels, and, perhaps most importantly, that the previously surveyed expectation among Australian households that rates would rise two to three times in the year ahead has likely evaporated. Today the average Australian family probably expects unchanged rates and/or more cuts.
As I have pointed out before, this means that the “expectational” impact of the RBA’s November cut will be significantly larger than would otherwise be the case.
Have you ever noticed how there tends to be relentless media coverage of deteriorating housing affordability when prices rise, but next to nothing written about improving affordability when prices fall? Without a shadow of doubt, this is the biggest story in the Aussie housing market today.
RP Data-Rismark’s estimate of the national median dwelling price across all regions and dwelling types has fallen from a recent high of $420,000 to $400,000 today. So the cost of Australian housing is unambiguously lower than it was one to two years ago. Concurrently, discounted fixed and variable mortgage rates are now well below their long-term historical averages while disposable incomes per household have been expanding at a healthy 8% per annum pace, according to the ABS’s National Accounts. This has resulted in Rismark’s national dwelling price-to-income ratio falling to its lowest level since before 2003. It is little wonder that first time buyers are returning to the market.
The striking improvement in Australian housing affordability is one reason why Rismark is projecting that there will be a sustained recovery in housing activity by the end of the first quarter next year.
While I am not in the least bit concerned about
Data flows over the past month or two have confirmed that consumer spending and housing credit are expanding at “new normal” rates that are near household income growth, as you would expect.
Notwithstanding the rhetoric about the specter of a global recession, surveyed business confidence and business conditions remain at trend-like thresholds, which helps explain why business credit growth has recovered of late.
And despite a step-down in job ads and employment growth, Australia’s unemployment rate has remained sticky at a touch above its “full-employment” level.
Beyond the ABS’s small and volatile unemployment survey, we can get further labour market insights by parsing the more comprehensive unemployment benefits data reported by the federal government. In absolute terms, the number of people on the dole has been declining consistently right through to the end of October (see first chart). Expressed as a share of a growing labour force, the decline in dole recipients would be even sharper. There are no signs here of a labour market that is “rolling over”.
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The government has created a second series that tracks the number of dole recipients who have been looking for jobs for a relatively short period of time. This is illustrated in my next chart. The main take-away is that the number of people looking for jobs has been falling, not rising, albeit at a reduced rate in 2011 compared to the steeper declines evidenced in 2010.
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Finally, last week we got a major upside surprise with the ABS reporting that “construction work done” in the third quarter printed at +12.5% – its highest rate on record and way above consensus forecasts of a +2% increase. Economists believe that this variable alone has the potential to add as much as 1.5 percentage points to the critical third quarter real GDP data.
The available empirical evidence implies that
While we always knew that a narrow resources investment boom would make this the case, one tends to hear much more from the noisier “have nots”. This can in turn blur one’s vision in respect of the broader economy’s performance.
Telescoped sources of economic growth can also interfere with the integrity of numerical surveys (or polls) of business conditions/confidence if participants’ responses are not weighted by their contributions to overall growth.
The bottom line is that based on the hard data and the RBA’s forecasts for gradually increasing core inflation over the next few years there seems to be no prima facie case for a rate cut next week.
This view was reinforced by the RBA’s top economist, Dr Phil Lowe, who explained, for the avoidance of any doubt, that following the November rate cut domestic “interest rates now are broadly neutral. They're neither expansionary … nor contractionary for the economy.”
While most economists currently expect the RBA to stay its hand in December, the financial markets have been pricing in a 100% probability of a cut for some time.
The interest rate debate is swirling around what experts think is the RBA’s “policy of least regret.”
In this context, there is universal agreement that the chief near-term risk
The concern is that if the banks feel they cannot fund themselves, they will ration credit, and, by doing so, rather myopically kill off economic growth. Of course, we have been here before during the GFC, and know that contrary to some predictions, the banking system did not fall in a heap.
Why? Because the Government decided to lend its pristine AAA credit rating to all ADIs by providing a taxpayer guarantee of deposits, which make up 50-60% of total bank funding, and through an offer of a taxpayer guarantee of the banks’ wholesale debts. In addition to these two insurance policies, the RBA also lent directly and very cheaply to the banks to provide them with enough funds to meet their day-to-day liabilities. Had the Government and the RBA not acted in this way, many Australian banks would have ended up trading insolvent.
The good news for the banks is that the RBA is in the process of launching another, more formal, bail-out program called the Committed Liquidity Facility, which will furnish banks with a line of credit that they can tap during liquidity crises such as the current one.
The RBA is the first to admit that it does not know what is going to happen in Europe, and what, if any, adverse economic shocks might be sent Australia’s way. It has ample time to watch how things unfold.
If the “nowcasting” Glenn Stevens is increasingly fond of reveals that the economy is about to come to a grinding halt, and if unemployment starts to rise at a surprising rate, he can comfortably cut rates.
Yet dropping rates today in response to bank funding problems prior to his nowcasting telling him to do so is foolish for at least two reasons.
First, there are many much more direct policy measures that can be used to immediately cauterize these issues, such as the assorted taxpayer guarantees and RBA liquidity facilities discussed above.
A cut in interest rates, on the other hand, is likely to be almost entirely absorbed by the banks in the form of margin expansion, which they would argue they need in order to vouchsafe their profitability.
This has two adverse consequences for the RBA and taxpayers.
The first is that if the RBA cuts its cash rate, and the banks don’t pass it on, this undermines the effectiveness of the RBA’s conventional monetary policy instrument. There is a zero lower bound on how far the RBA’s cash rate can go.
If you assume that banks want to maintain, as a minimum, net interest margins of around 2.5%, it is hard to see how mortgage rates can fall below circa 3% to 3.5%. And that assumes no further margin expansion by the banks along the way, which is heroic. So the RBA probably has the ability to reduce actual lending rates by about 300 basis points, give or take.
The point is that the RBA wants to be very careful to disentangle the policy solutions to bank funding problems and those required to stop an economy heading into recession (especially when fiscal policy is purportedly out-of-action).
Confusing the two could hamper your ability to lower market lending rates and thus stimulate the wider economy. Put differently, the RBA should preserve its policy firepower for when it needs it rather than using it to subsidise bank margins.
The issue for households is that if banks absorb RBA cash rate cuts via margin expansion, the RBA is, in effect, facilitating a wealth transfer from the 5 million families with mortgages, who will not get the benefit of lower rates, to bank executives and bank shareholders.
Don't get me wrong. A sustained deterioration in global economic conditions would absolutely warrant deep cuts by the RBA. Yet unlike its peers overseas, the RBA is in the fortunate position of having most domestic debt being issued in ‘variable rate’ form. This means the RBA can make immediate and very significant changes to household cash-flows through adjustments to its policy rate. In many other countries, such as the
Christopher Joye is a leading financial economist. The above article is not investment advice.