The RBA's focus appears to have shifted since the GFC

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The Reserve Bank of Australia (RBA) has three clear mandates when it comes to interest rate settings: inflation, full employment, and the economic prosperity and welfare of the Australian people.

For the best part the bank has managed to achieve those goals, making a solid contribution to Australia’s near-unprecedented run without experiencing a recession.

However, while it has three mandates, the RBA’s priorities appear to have shifted in the post GFC-era, according to new analysis from ANZ.

It’s tended to adjust policy to developments on inflation, rather than to what’s happening with the labour market, in recent years.

And economic uncertainty is also playing a more important role than what was the case in the past.

“The RBA now seems to be more sensitive to below-target inflation than it was in the past, says David Plank, head of Australian economics at ANZ. “That is, all else equal, when inflation is below target the RBA is now more likely to cut the cash rate than it was in the past.”

This chart from ANZ demonstrates the increased sensitivity the RBA now has to low inflation outcomes compared to the period before the global financial crisis.

Source: ANZ

These low inflation readings have led to more rate cuts that what would have been in the past.

“This may be partially explained by the fact that, in the post-2009 period, inflation has been persistently below the RBA’s inflation target, thus pushing the RBA to react more aggressively to low inflation,” says Plank.

However, while inflation appears to have increased in significance, rate settings towards developments in the labour market have moved in the other direction.

Source: ANZ

Compared to the pre-GFC era, the RBA on recent form is less likely to respond to elevated levels of labour market slack, something that has been seen in recent months with policy being left unchanged despite record-high levels of underemployment.

“This may be partially explained by the fact that the unemployment rate is no longer a good gauge of spare capacity in the labour market and other, broader measures of slack (such as) the underemployment rate may now have a larger influence on the RBA’s reaction function,” says Plank.

He also says that economic uncertainty also appears to be more influential on the RBA’s thinking, noting that this likely reflects growing imbalances in the economy such as rising concerns around financial stability, the debate around underemployment, and possibly a stricter interdependency of Australia with the rest of the world.

So, with the RBA seemingly putting more emphasis on inflation and economic uncertainty than labour market conditions, where does that leave the outlook for interest rate in the period ahead?

Based on modelling conducted by ANZ, used to determine the shift in policy focus seen in recent years, Plank says that the cash rate is expected to remain unchanged for well over a year.

“Our model for the RBA reaction function estimates there is a 75% chance of the Bank being on hold over the coming 12 months — which compares with an historic average of 62% — with 15% probability of a cut and 10% probability of a hike,” he says.

“This suggests to us that risks for the cash rate continue to be skewed to the downside.”

Plank says that for the RBA to even consider raising rates, it will need to see clear evidence that core inflation is trending sustainably higher.

“A premature tightening of monetary policy may result in even lower inflation outcomes that will have negative implications for wages, among other things.”

While the ANZ model suggests that rates will remain on hold until well into 2018, perhaps adding uncertainty towards the outlook for policy is that RBA governor Philip Lowe has only been in the job for a little over six months.

Much of the decision-making process in the years following the GFC would reflect what indicators former governor Glenn Stevens deemed to be of more importance.

His successor has put more weight on financial stability risks, particularly towards household debt levels, providing little indication since he took the top job in September last year that there is a need to cut rates despite weak inflationary pressures and elevated levels of labour market slack.

However, while financial stability appears to have taken on more importance, that will still have to be weighed against developments in inflation and labour market conditions, particularly should they not improve as the RBA’s forecasts currently suggest.

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