RBA Minutes – time to evaluate now needed

In the Minutes issued yesterday, the RBA continued to do what it did last month; to explain why it had toned down the dovish bias, leaving limited scope to ease further in the immediate short term. Accordingly, we suspect the recent easing will be the last for some extended period of time. If estimates of domestic and global growth moderate from current levels, then further easing beyond 2.50% may then become possible. Also, it should be noted that the much anticipated post-election growth spurt now requires careful assessment by the RBA.

International economic conditions assessment

Overall, the assessment of global growth was consistent with that given over the recent months, but with a somewhat more upbeat assessment of global growth. The European economy was noted to have expanded for the first time in many years. Another upbeat assessment of China was provided:

Overall, growth of Australia's major trading partners in the June quarter was around its average of the past decade and recent indicators suggested that this pace of growth had continued. The Chinese economy was growing at around the pace evident since the start of the year, and members noted that indications were that GDP growth was likely to remain close to the authorities' target of 7.5 per cent over the remainder of the year. Growth had been driven in large part by domestic demand, with demand for property continuing to rise, although perhaps at a slower rate than earlier in the year. Along with strong growth of infrastructure investment, the demand for property was underpinning the demand for construction materials.

The RBA also acknowledged that commodity prices had begun to rise, unlike the prior minutes, where stabilisation of prices was noted.

Domestic assessment

Monetary policy was observed, once again, to have obtained more traction throughout the economy.  There was an improvement in the outlook for dwelling investment and the auction clearance rate, given the impact of low interest rates. A subdued labour market was apparent with only modest prospects for labour force growth:

• consumer spending was observed to have remained below average, although sentiment had improved above average
• business sentiment  was still fragile, leading to aversion to new investment
• wages cost growth was generally seen as remaining low, with consumers concerned about rising unemployment, while inflation expectations remained low

Importantly, the RBA noted that the outlook for the construction sector was improving:

Conditions in the housing sector had continued to improve in response to lower interest rates. Information to hand suggested that building activity had increased moderately in the June quarter and building approvals increased in July. Dwelling prices had increased further over recent months, to be 7 per cent above their trough in the middle of the previous year, auction clearance rates were noticeably higher than a year earlier and housing turnover had increased from relatively low levels. Overall, recent data and information from liaison were consistent with further recovery in the established housing market and moderate growth in dwelling investment.

Financial markets

Like last month, there was some interest in the discussion of the rise in global bond yields and the market perception of a change in US monetary policy. However, the comments on emerging markets were of most interest given the AUD is impacted by developments in these countries and the RBA is keen to see the currency lower (so as to stimulate the non-mining sector). As the RBA note,

Members observed that the most notable impact of the change in expectations about US monetary policy had been on emerging economies, where capital outflows had put downward pressure on exchange rates and caused domestic bond yields to rise sharply. While many emerging market economies were affected, those countries that were generally perceived to be more reliant on foreign capital had experienced the most pressure, including Brazil, India, Indonesia and Turkey. Exchange rates in these particular countries had declined by around 5–10 per cent over the past month and by around 15 per cent since the end of April, notwithstanding steps taken to moderate capital outflows or offset their impact. In most cases, the authorities had undertaken exchange rate intervention, although other tools, including higher interest rates as well as restrictions on capital outflows, had been used in some cases.

Also, the RBA highlighted that interest rates were now at “historically low levels”.

Financial stability

Here, the RBA referred to the main factor that is currently blocking the transmission of monetary policy to the broader economy; the conservative consumer:

Members noted that conditions in the domestic business and household sectors had changed little in the past six months. Although business failure rates remained above average, business balance sheets were in good shape overall. The period of deleveraging following the global financial crisis appeared to have ended, but at this stage gearing ratios in the listed corporate sector were only slightly above their recent troughs. Households continued to show prudence in managing their finances, with higher levels of saving and a slower pace of credit growth in place for some time. Members observed that the continued high rate of excess home loan repayments was consistent with low rates of financial stress among households with mortgages. Property gearing in self-managed superannuation funds was one area identified where households could be starting to take some risk with their finances; members noted that this development would be closely monitored by Bank staff in the period ahead.

Hence, while rates are historically low, the conservatism of the consumer is effectively neutralising the stimulatory position of rates, thereby making monetary policy not as stimulatory as it appears; simply with reference to history.

Considerations for monetary policy

Sub-trend economic growth, slowing wages growth, a high AUD, a cautious consumer, combined with sub-trend employment growth and a declining level of business investment, all supported the general background behind the easing in August. While the RBA had seen that there was scope for further easing in monetary policy in August, it highlighted that it had already provided a large amount of easing to the economy:

The decision to reduce the cash rate at the August meeting, where the Board had judged that the outlook for inflation provided the scope to ease monetary policy further, brought the total reduction in the cash rate since late 2011 to 225 basis points. Lending rates had declined to historically low levels as a result, which, together with the lower – though still high – exchange rate, were continuing to provide a substantial degree of policy stimulus to the economy.

Against that background, some evidence of improving dwelling construction was noted to have emerged. We argue that all these considerations, especially the expected post-election surge in activity, led the RBA to moderate forward guidance, which is noted in the last paragraph as follows:

Given the substantial degree of policy stimulus in place, the Board judged that it was appropriate to retain the current setting of interest rates. Members agreed that the Bank should again neither close off the possibility of reducing rates further nor signal an imminent intention to reduce them. The Board would continue to examine the data over the months ahead to assess whether monetary policy was appropriately configured.

In other words, the RBA indicated that we have come a long way in terms of monetary policy, which means that shorter term bonds have little cause to rally when compared to longer bonds, which are now roughly 150 basis points above the cash rate. As the weakness of the economy becomes more apparent next year, the cheapness of longer bonds should become more apparent, which then should lead the yield curve to flatten; long bond rates will more closely approximate the current level of short bond rates.

Conclusion

Markets have now moderated expectations that the RBA will ease monetary policy in the short term, so that they are now much more in line with our recent point of view, as expressed last month. Specifically, we think that those expectations for another may well be realised, although realisation is more a question for 2014, as opposed to 2013. In the aftermath of the forthcoming post-election growth spurt, expectations of further RBA easing will vary substantially. Overall, we estimate that cash rates will be left roughly unchanged in the post-election period since nine months of pent-up investment commitments, as created by the long election period, are finally executed. Such execution of plans should see short term activity surge, and thereby place a short term easing off the RBA agenda for 2013.

Make no mistake; the US mid-term election cycle for 2014 has already started, with the resumption of the US Congress so political risk is back on the agenda for investors. If, and it is a big “if”, all is quiet on global financial markets, the spurt of growth that we see into year-end should not lift growth permanently above trend, and a settlement back to sub-trend growth should become more apparent during early to mid-2014.

Apart from other things, a cash rate that equals the medium term inflation rate will mean that investors need to obtain better returns, when compared to cash, in the fixed income markets, so as to smooth turbulence from somewhat optimistic equity markets.