Phillip Lowe, the newly installed Governor of the Reserve Bank of Australia, is already clearly delineating his own particular set of priorities with regard to monetary policy. From recent RBA publications and speeches, Lowe has been unusually candid in outlining his thinking.
And for those still harbouring the view that the RBA could cut interest rates again in the next few months, the message is a disappointing one. Even though underlying consumer price inflation seems unlikely to rise back into the RBA’s 2 to 3 per cent target band anytime soon, the Bank is not as inclined to cut interest rates as it was last year.
Why the reticence? Because the Bank is growing more worried that a further cut in rates might do little to lift inflation quickly, and instead might overly add to household borrowing – and hence add to the risk of an abrupt downward adjustment in consumer spending down the track.
The RBA is balancing two risks: the risk of letting inflation expectations drop too far if is allows inflation to remain too low for too long, against the risk of allowing household debt to rise too far too fast, and hence generate greater downside risks for the economy and inflation later.
Last year, the RBA’s emphasis was on the risk of letting inflation entrench itself below the RBA’s 2 to 3 per cent target band. With that in mind, the RBA cut rates twice because annual underlying inflation failed to hold above 2%, but instead sunk to 1.5%.
My own view some months ago was that, based on this framework, the RBA would likely feel the need to cut interest rates again this year – as it seemed unlikely that annual underlying inflation would head back up to the 2% level the RBA was anticipating by the June quarter 2017.
And with inflation lower than desired, and the unemployment rate also higher than desired, the onus should be on the RBA to cut rates to encourage the economy to grow at a somewhat faster.
Or so it seemed.
But what appears to have irked the new Governor is the fact that the frothy housing markets of Sydney and Melbourne roared back to life on the back of last year’s rate cuts. As noted in this month’s Statement on Monetary Policy “conditions in the housing markets of Sydney and Melbourne strengthened over the second half of 2016..” Indeed, it was earlier signs of a tempering in the frenetic house prices gain in both cities – perhaps helped by a tightening in lending standards – that has encouraged the Bank to adopt an easier attitude to policy last year.
Another concern is the mid-year slowdown in consumer spending, which appears to have reflected a reluctance of households to cut their saving rate any further given low wage growth and the build-up in debt levels. For a year or so, both the RBA and Treasury have been counting on a declining household savings rate to support consumer spending, but the RBA at least is no longer making that assumption – and has recently scaled back its consumer spending forecasts accordingly. This development has likely highlighted to the RBA just how fragile the vitally important consumer sector really is, and so has underlined the risk of excessive debt build-up, and a subsequent slump in consumer spending later.
As the Governor noted in Parliamentary testimony this week, balance is required “to support spending in the economy today while avoiding creating fragilities in household balance sheets that could cause problems for the economy later on. This is also something we need to watch carefully.”
So what about the risk of entrenching low inflation expectations by letting inflation stay too low for too long? Note this risk was not even mentioned in this week’s parliamentary testimony, and it was downplayed in a recent speech by Lowe when he indicated “at the moment though, I don’t see a particularly high risk of this in Australia. The recent lift in headline inflation is helpful here and most measures of inflation expectations are within the range seen over recent decades.”
Given these trade-offs, moreover, Lowe has been at pains to urge Government’s to boost infrastructure spending – as this could support growth and inflation without requiring households to borrow and spend more, and thereby place added stress on their balance sheets.
To my mind, all this suggest that interest rates remains firmly on hold – even in the face of likely further low CPI reports. To get a rate cut, we’ll also need to a see a clear weakening in the labour market, such that the unemployment heads back above 6 per cent. On current trends, that does not seem likely either anytime soon.