The RBA's Dilemma
The differences in philosophy between the Reserve Bank of Australia and the United States Federal Reserve are becoming starker, which will not make of the job of the RBA any easier in coming months.
If the US Federal Reserve continues to delay raising US interest rates, the RBA will have to choose between, on the one hand, and uncomfortably high exchange rate and unemployment or, on the other hand, uncomfortably high Sydney and Melbourne house prices.
The key difference between the two central banks is their attitude to asset prices. The RBA takes a more concerned attitude to the impact of low interest rates on asset prices – to the extent an untoward rise in the latter could have destabilising effects on the economy later should bubble conditions develop and inflated asset prices eventually crash.
At the Fed, however, officials are resolutely focused on current trends in unemployment and consumer price inflation – and seem determined to keep interest rates low to guard against deflation even if this contributes to runaway equity prices and mis-pricing of risk premiums (again!) in credit markets. The Fed’s philosophy is merely to stand ready to support markets if they crash, but wash its hand of any responsibility for creating bubble conditions in the first place.
Being an active participant in the global currency wars, moreover, the Fed is also concerned that the US dollar does not rise too far too fast, as it could crimp US exports and add to downward pressure on already low inflation.
As a result, while the Fed dropped the key word “patient” from its post-meeting policy Statement this week, Fed members also revised down their economic growth outlook and their expectations for how fast US official interest rates will rise over the next year. Wall Street jumped on the news, and many analysts now reckon the Fed won’t raise interest rates until at least September – some six months away. And that’s despite the fact America’s unemployment rate is already down to 5.5% - very near what even the Fed considers full employment.
In turn, the US dollar sunk and the $A jumped on the news – hitting US78c. The $A is still close to the levels it was when the RBA cut interest rates last month.
So what do to? The RBA baulked at cutting interest rates this month and there’s speculation it’s still reluctant to cut interest rates next month due to the continued strength in property prices. If both the Fed and RBA baulk at doing anything in coming months, there’s a good chance the $A could be squeezed higher as the extensive short positions already in the market unwind.
Meanwhile, apart from rising property prices there’s little reason for cheer in most other parts of the economy. Indeed, commodity prices continue to sink, and business and consumer confidence are still subdued – even after the last rate cut. Canberra’s antics are hardly inspiring any confidence in the business community either – with Prime Minister Tony Abbott now promising that the May budget will be “dull.”
Therein lies the dilemma for the RBA: does it cut rates and risk stocking house price further, or hold rates steady and risking the $A and unemployment rising instead?
In an ideal world, the Fed would be raising interest rates due to the strength of the US economy – which would help lower the $A and take pressure off the RBA to cut interest rates further. The RBA’s dilemma could also be overcome if APRA were able to effectively reign in excessive lending to property investors through its new set of so-called “macro-prudential” controls. But the RBA seems to be lacking confidence that these controls will have much effect.
My own view is that the RBA should cut rates – and without delay. Given that house price gains are not widespread across the country, it’s not clear that interest rates are the main driver of the upward pressure in Sydney and Melbourne. These markets should be allowed sort themselves out, with rising prices eventually reducing both affordability and demand. The rest of the economy should not be held hostage to the development in one sector of one or two (albeit important) cities.
Whether the RBA sees it my way remains to be seen. Either way, I still expect the RBA will cut rates in either April or May. And later this year, based on my view our economy will remain weak and unemployment will move higher, I can’t see the RBA not feeling the need to respond by cutting rates another couple of times.
David is one of Australia's leading economic and financial market analysts. His is Chief Economist with BetaShares, and an Economic Advisor to the National Institute for Economic and Industry Research (NIEIR). His has held former roles as senior commentator with The Australian Financial Review, Macquarie Bank interest rate strategist and Federal Treasury economist. He is also author of the online e-book, TheAustralian ETF Guide.