- Former RBA board member Warwick McKibbin believes the bank should start to lift official interest rates, pointing for the need to move away from inflation to nominal GDP policy targeting.
- Mark Crosby and James Morley, two academic economists, agree the RBA risks “falling behind the curve” by leaving policy unchanged at current levels.
- Most traders, analysts and market-based economists believe the RBA will keep official interest rates steady well into next year, perhaps longer.
While most traders, analysts and market-based economists believe the Reserve Bank of Australia (RBA) will keep official interest rates steady for the foreseeable future, that’s not the view shared by some academic economists in Australia.
Hot on the heels of former RBA board member Warwick McKibbin suggesting the RBA should lift rates now to help build an buffer for when the next economic downturn hits, Monash University economist Mark Crosby and Sydney University’s James Morley, two members of the Australian National University’s “shadow” RBA board, believe now is the time for a more “normal” cash rate in Australia.
Like McKibbin, also a member of the shadow board which analyses and critiques actual RBA policy decisions, Crosby and Morley suggest that now is the time to begin normalising policy, even with wage and inflationary pressures remaining low and concerns about Australia’s heavily indebted household sector elevated.
“They keep delaying and finding reasons not to move up,” Crosby told the Australian Financial Review. “Whereas my view is it’s safe enough to do so and the more you delay, the more imbalances build up.”
Crosby described the current level of interest rates as “unhealthy”, suggesting the RBA should look to unwind the two 25 basis point cuts it delivered in 2016 when inflationary pressures fell well below the bottom of the RBA’s medium-term target.
“We shouldn’t have cut rates the last two times,” Crosby says.
“The economy wasn’t weak enough to warrant it. It’s just getting rates back to something more normal.
“With debt levels where they are, house prices where they are, and an economy as robust as it is, now is the time to raise rates.
“Even though inflation is low, why not move to something more normal?”
Like Crosby, Morley of Sydney University suggests fears over what higher interest rates could do to the Australian economy are overblown, particularly at a time when the economy is growing at an above trend pace and the labour market moving back towards full employment, regarded in some circles, including the RBA, as an unemployment rate of around 5%.
“Returning rates to neutral if the economy is close to its potential level — for which there is lots of evidence, like the labour market — then returning rates to neutral within the next year seems like a sensible strategy,” Morley told the AFR.
Given how things currently stand, he estimates there is a 90% need for the official cash rate to be higher over the next 12 months, adding the cash rate could lift to 2%, or even higher, without weighing on the economy.
He called for the RBA to show faith that firmer economic growth and strong labour market conditions will lead to faster wage and inflationary pressures in the future.
“Are they as bleak in their heart-of-hearts? They must believe the economy is running close to potential and that the labour market will at some point feed through to wages and prices growth,” Morley said.
Like McKibbin, Morley suggests that with both policy and market interest rates rising around the world, the longer the RBA retains the cash rate at current levels, the greater the risk is that it could lead to a substantial depreciation in the Australian dollar.
“For an open economy like Australia’s, what’s happening abroad among major trading partners is an important reference point for the interest rate position,” he said.
“You don’t want interest rates too much out of line as it can lead to massive shifts in capital outflows, and put very big downward pressure on the Australian dollar.”
Despite interest rate differentials between Australia and the United States turning negative, and widening, for the first time in several decades, that hasn’t seen the Australian dollar collapse as yet, largely reflecting strength in Australian terms of trade as a result of firmer commodity prices.
The Australian dollar has also held up well against other major crosses, despite narrowing interest rate differentials.
Given their views, and despite the Australian dollar holding up well, both Crosby and Morley suggest the RBA risks falling behind the curve with policy settings, particularly at a time when the US Federal Reserve is forecasting that it will lift its Fed funds rate five more times by the end of 2019.
That implies that should firmer economic growth lead to faster wage and inflationary pressures, at a time when the Australian dollar is falling, it could see the RBA lift official interest rates faster and higher than it and many expect.
While that is a risk, it’s also highly speculative.
It’s also a very different view conveyed by most in financial markets who expect the RBA will leave the cash rate steady until it’s confident enough that the economy is heading in the right direction.
Financial markets aren’t fully priced for 25 basis point increase in the cash rate until November next year.
Market-based economists share a similar view with most forecasting that the RBA will sit on the sidelines until early 2019 at the earliest. Some think it will be 2020 before the the cash rate will begin to increase given slow progress in eliminating excess capacity in the Australian economy.
The question comes down to whether the economy will be able to hold up to a preemptive lift in official interest rates, all in the name of building interest rate buffers for when the next downturn hits?
While true that economic growth did accelerate in the 12 months to March, the unusually large increase was just that — unusual — driven largely by a recovery in commodity exports, strength in government demand and a rise in business inventories.
Two of those three factors — net exports and inventories — are unlikely to make such large contributions in the current quarter.
The strength in headline GDP also masked weakness in household consumption, the largest part of the Australian economy. While true the result followed a strong increase in the December quarter of 2017, even with strong levels of population growth, household spending over the year remained below historic trends.
With wage growth remaining low, leading to weakness in household incomes, is now really the time to begin nomalising interest rates, particularly at a time when inflation is still low?
Higher rates will likely tighten Australian economic conditions, placing upward pressure on both borrowing costs and the Australian dollar.
Given the RBA’s forecasts that stronger economic growth will lead to a gradual reduction in unemployment and lift in inflationary pressures seem to be playing out, at least at present, it appears unlikely that it will see the need to take preemptive policy tightening, especially given uncertainties that exist within the household sector.
Is it worth risking an economic slowdown now by trying to build buffers for when the next downturn hits, whenever that will be?
While it would be nice to have a greater amount of monetary policy ammunition, the answer right now is almost certainly no.
Policy should tighten when data confirms the economy is improving, not based on speculation that it will improve.
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