Wednesday, August 06, 2008

Going down

One rate cut at a time

Australia’s Reserve Bank has put beyond doubt its desire to cut interest rates, saying in a statement after its Board meeting that the scope for cutting rates is increasing.

The confirmation, in the final paragraph of the statement, reads, “with demand slowing, the Board’s view is that scope to move towards a less restrictive stance of monetary policy in the period ahead is increasing.”

“There is now an explicit bias to ease,” said BT Group’s chief economist Chris Caton on reading the statement.

“The Bank has cleared the way for a September rate cut,” said Wespac’s chief economist Bill Evans.

Within minutes of the statement the futures market had priced in a 100 per cent probability of a cut at the Reserve Bank’s next board meeting on Tuesday September 2...

Before the statement the market priced in an 86 per cent probability of a September cut and a 14 per cent probability of no change.

The turnaround reflects the statement’s unusually direct hint that the board is considering cutting rates and also the absence of the usual assertion that “the current stance of monetary policy remains appropriate”.

Mr Evans said the last time the bank changed direction on rates in February 2005 it used similar wording to prepare the markets for a move the following month.

“We would put this statement firmly in that same category, and therefore expect a rate cut in September, as long as the intervening data does not warrant a substantial upgrade of the outlook for demand,” he said.

The bank will spell out its intentions more clearly in its major quarterly report on the economy next Monday.

Tuesday’s statement confirms that the Bank expects inflation to remain near its current long-term high of 4.5 per cent for some time before falling back to the Bank’s 2 to 3 per cent target zone in 2010.

It says household spending is “subdued” and credit growth has slowed significantly. Business activity is “softening”, and there are early signs of an easing in labour market conditions.

The statement makes clear that this is the sort of slowdown the bank has been trying to achieve with its series of four interest rate hikes since August last year.

It says additional hikes imposed by lenders themselves have resulted in “further tightening” over the past couple of months.

“The evidence is that the tightening in financial conditions, in conjunction with other factors including rising fuel costs and lower asset values has restrained demand,” the Bank said.

The statement notes that Australia’s rising export income “is working in the opposite direction” but it says on balance it expects Australia’s economic growth to be “fairly slow”.

The Treasurer Wayne Swan said it was unhelpful to talk about recession that the government would “use all the levers that we have, that we control, to get the desired outcomes”.

The Chief Executive of the Australian Industry Group Heather Ridout called on Australia’s banks to fully pass on any interest rate cuts instigated by the Reserve Bank and not to increase rates in the meantime.

4 comments:

Anonymous said...

I can't help but feel a bit confused about this.

Having read the Reserve Bank Governor's statement, it didn't seem to indicate to me that interest rate cuts were guaranteed. In addition to the downsides mentioned (an argument for reduction of rates), Mr Stevens also noted that there were risks to higher inflation and he is expecting continuing solid growth in the resources sector.

So why is the market saying that it is certain of a rate cut next month? If the RBA has made up its mind in cutting rates why didn't it do so yesterday? What is expected to change in the next month that will make it inevitable that they will cut rates then? Is it about perfect timing or is there another explanation?

Al

Peter said...

Thanks Al,

It wants more data to confirm what it has observed, and it wants to prepare the market/media for a cut.

Graeme said...

My view is that monetary policy control boards (all over the world) ALWAYS over-shoot. In science/engineering, 'controllers' to keep some value on track are "PID controllers", meaning proportional, integral, differential. A good explanation is at http://en.wikipedia.org/wiki/PID_controller

If you ONLY look at where you are and where you want to be, you are a proportional controller, eg your vehicle speed is currently 80kph and your target speed is 100kph, so you keep applying the power. All proportional-only systems overshoot, and it takes many many oscillations for the system to eventually settle down. That is where the "integral" bit should come in, where you need to start tempering your inputs earlier (to avoid the way a beginner-driver over-corrects when trying to first steer).. This allows you to smoothly approach a target(a 'soft landing'), rather than over-shooting.

With a new car, push down on one corner of the car and release. It returns smoothly to its normal position. The spring is the proportional bit, whereas the shock-absorber does the dampening. Good shock absorbers are the 'integral' part of the control mechanism. But with a very old car, the spring still works, but the shock-absorber is worn out. So the corner bounces up and down for a long while, till it finally settles down.

Sorry for labouring the physical analogy, but macro-economic management could learn a lot from control theory. It helps understand why the RBA (and all bodies like them) consistently get it so wrong (take so long to act).

Anyway, I think the RBA should have cut just 0.25 this past time, just to "intentionally muddy" the signals. That would have stopped some free-fall in certain markets, including real estate, allowing people to sense that they were approaching a 'bottom'. Otherwise, the gloom goes through a 'reverse multiplier effect' where gloom causes cancelled orders, which causes more gloom in capital supply businesses, which causes more dampening of overall demand, in a vicious circle. None of those things are going to cancel any resource projects already in progress, but will cause mayhem in many other industries! The 0.25 would have been "neither here nor there" in terms of overall borrowing costs, but it would have put some confidence that 'the world is not ending' back into the system.

The RBA think the test is for them to not be seen to flip-flop, whereas the direction of that input signal doesn't matter - all that matters is the smooth performance of the values being controlled (ie controlled/gradual adjustment of growth rates).

The problem is that the learner driver goes 10-20 years between lessons. So over-correction always happens, as the board has changed. Better to build them a simulator, to let them re-experience the mismanagement of past booms/busts. You need to be act according to sentiment, to avoid the over-correction inherent in using months-old data to steer by! Next time you're driving try closing your eyes and having a passenger relate what's happening to you. That extra delay causes lots of over-steer!
Graeme Harrison (prof at-symbol post.harvard.edu)

Anonymous said...

Thanks Peter

Al

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