| The RBA Will Come to the Party, But is it Don’s Party? |
| Wednesday, 10 October 2007 | ||||||||||||||||||||||||||||||||||||||
Page 2 of 10 The underlying position of the Australian economy is very strong. It is, in my view, very, very likely that the RBA will raise rates within the next 3 months or so. The far more intriguing question is whether or not the RBA will raise rates before the next Federal election. As I write, the Federal election has not yet been called, but I am writing on the assumption that the election will be between 24 November and 8 December, probably later rather than earlier.
It is possible to mathematically calculate the chances of a rate rise priced into the Australian market. Currently, (as shown in the graph) the market is expecting a rate rise somewhere between November and February. Rather like the Federal election, we know a rate rise is coming but the timing is, as yet, unclear. In order to get an impression of what the RBA is likely to do – and when they are likely to do it ‑ we must first understand what the RBA is trying to do and then what complications are getting in the RBA’s way.
There is an agreement between the RBA and the Government that outlines rights and responsibilities of each party. Essentially, it says that the RBA is completely independent, but should conduct monetary policy with the aim of: (a) maintaining “the stability of the currency of Australia”. This is a roundabout way of saying keeping inflation low. (b) maintaining “full employment in Australia”. (c) providing for the economic prosperity of Australia. Although there is no specific hierarchy of these objectives, it is generally understood that the maintenance of inflation “between 2 and 3 per cent, on average, over the cycle” is the most important objective. It is the only objective that is discussed further and quantified in the agreement and also the only objective the RBA has a realistic chance of achieving on its own. The RBA can assist in maintaining full employment and providing economic prosperity, but, in reality, the Government of the day is more better equipped to achieve objectives (b) and (c) than is the RBA. It is important to note that the inflation target allows for some flexibility by targeting 2 ‑ 3% inflation over the cycle. There is a significant difference between 2 ‑ 3% over the cycle and 2 ‑ 3% at all times. Inflation could breach 3% and not provoke a response from the RBA if there were good reasons to assume that the rate was already falling and so was still likely to remain between 2 ‑ 3% over the cycle. This would be an unusual situation, but is far from impossible. “Inflation” in this context refers to the increase in the Consumer Price Index or CPI. The CPI is released in Australia quarterly, approximately 4 weeks after the each quarter-end: in late January, April, July and October. There are RBA meetings around two weeks after the CPI releases in early February, May, August and November. Although the RBA meets monthly, these post-CPI meetings are, generally, the most likely to result in rate moves because they are the RBA meetings where the information about CPI is best. The last four rate increases were in May-06, Aug-06, Nov-06 and Aug-07 ‑ each following directly after a high CPI. The next CPI release is on 24 October. Although we don’t know what the CPI figure is yet (anyone from the ABS who’s feeling talkative, please contact me!) there are good reasons to assume that it will be high. Petrol and Food have been rising in price. There have been many articles in newspapers and the like highlighting the approximately 20% per annum rise in rents which in turn are 5% of the CPI. It’s a trifle simplistic, but if the 20% increase in rent is even vaguely correct it could 1% p.a to the CPI by itself (20% x 5% = 1%). Secondary indicators of inflation are also pointing to a reasonably high CPI result. Retail Sales have been very strong which indicates there is a lot of money being spent. Employment remains very low, indicating that most people have jobs and therefore most people have money to spend. The more people that have jobs and are spending money the more likely it is that prices will rise. At this point it is tempting to assume (as some of the more simplistic analyses in the media do) that the RBA will raise rates if the CPI is ‘too high’ on October 24 and leave them unchanged if the CPI is not ‘too high’. Although this is approximately true, there are also a couple of complications which also bear thinking about.
The complication is that there has been, over the past few months, significant stress in the Global banking sector. Banks borrow money from lots of places, not only at the rates the RBA sets. While the interest rate from the RBA hasn’t risen, the interest rate from almost everywhere else has. The best way to look at this is to consider the difference between a bank borrowing money from another bank for three months and a bank borrowing from the RBA every day for the next three months. The difference between these two has, historically, been around 0.1% or 10bp (a basis point is 0.01%).
In August, just after the US sub-prime crisis, the difference in interest rate between borrowing from other banks and borrowing from the RBA jumped from 5-10bp to about 50bp. It was, indirectly, the US sub-prime crisis which caused this problem. More specifically, it was the banks’ response to the sub-prime crisis which caused the problem. Globally, every bank knew that ‘some-one’ had lost lots of money on the US sub-prime market, but they didn’t know who. Consequently, all the banks became very nervous about lending money to anyone. Then it became a self-perpetuating problem. When it became hard to borrow money, all the banks began hoarding the money they did have, just in case, so money became even more difficult to borrow – and the interest rates on the money the bank’s could borrow went up quite noticeably. This global liquidity crises, as it is known, is very dangerous because it can spread very quickly. A profitable well-run bank can fail because it does not have enough cash on hand for a single day. That’s what nearly happened to Northern Rock in the UK. The global liquidity crisis was, in effect, as if every Central Bank globally had increased interest rates. It was an implicit tightening of interest rates globally. The net effect of all this is that the cost of borrowing money (for a bank) has gone up in Australia even though the RBA has not increased rates. In other countries, most notably the US, the Central Bank has needed to cut rates to counter-act this implicit tightening in policy. In the UK and Europe the Central Banks have retreated from raising interest rates because the implicit tightening did the work for them. The really complicated bit, is that the implicit tightening is now starting to dissipate. The 50bp difference in borrowing from other banks vs. borrowing from the RBA is starting to fall. The difference is now about 30bp and seems to be trending down. If there is another global scare, another bad headline, then the difference could spike up again very quickly. However, while the difference is currently sill high, it is dissipating. You can only suggest the RBA will raise rates soon if you are sure that there are no more surprises in the works from the US sub-prime market or the global liquidity crisis. I don’t think any remain, but you never know. It’s this “you never know” factor that might make the RBA pause in November. A high but not huge CPI might see the RBA leave rates unchanged while they wait to see if the sub-prime and liquidity issues are really finished. The CPI released on 24 October covers July-Sep, so is a little bit old already. If the CPI is only a little bit high, say around 3.1% or 3.2%, per annum, then the RBA might decide that although the CPI is higher than the target range, given the other and more recent concerns about liquidity, the course of action most likely to create “2 – 3% per year on average over the cycle” is actually to leave rates unchanged. A very high CPI would prompt a reaction of course, but a middling to high CPI may well see the RBA wait until December. It is worth highlighting that although the banks have faced a much higher cost of borrowing money, they have not yet tried to pass it on to their customers. There are exceptions, RAMS passed on a significant rise and Adelaide bank passed on a small rise to their Lo-Doc loans only. If the cost to the banks of borrowing money remains high, they may eventually pass the cost on the public regardless of RBA action – though this scenario seems less likely the more the liquidity squeeze dissipates. Complication 2: The PoliticsThis is a red herring, in my view. You will probably read about it in various sections of the media, but there’s not much in it. It is true that there is a long-standing tradition that Central Banks don’t raise rates during an election campaign. However, this is a custom that has grown up without it ever really needing to be tested in Australia. In the US, the Fed raised rates during the 2004 election campaign because the economics of the situation demanded it. There was not much of a reaction because everyone could see that they had to do it for sound economic reasons. Also, remember there are two sides of politics. Not raising rates when the economics demands it is just as political as raising them when the economics do not demand it. The RBA is independent, which means they look at the facts and the data, and do not look to help or hinder either the ALP or the Coalition. The RBA do not raise rates because they are masochists who like hurting little Aussie battlers. The RBA raise rates because they are trying to keep the Australian economy, as a whole, as strong as possible. They are fully aware that raising rates hurts people – but so does rampant inflation. If the CPI released on October 24 warrants it, the RBA will raise rates on November 7, election or no election, for the long-term good of the Australian economy. If the CPI is moderately high and the RBA decides not to raise rates on November 7 but over the course of November all the other secondary indicators show that inflation is rising (Retail Sales, employment) and the Global implicit tightening continues to dissipate then this will likely necessitate an increase from the RBA on December 5. My personal view is that December 5 is the most likely time for the next RBA interest rate rise, most likely either just before or just after the Federal election.
Summary of important upcoming dates:
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