Tuesday, March 09, 2010

Rory: Expect a much higher cash rate, unemployment got "too low" last time

"The truth is there’s only so much activity that can take place. And if we want to have all this mining investment and mining output, which is happening, basically the other parts of the economy for the moment have to be restrained somehow because the economy can’t do all these things simultaneously" - Ric Battellino

Rory Robertson:

The RBA has a clear bias to keep going, to keep hiking from the extraordinary low lending rates that were appropriate only while unemployment looked set to surge towards 8% or more.

In the short term, another hike from the RBA in the next three months remains highly likely. Longer term, with unemployment now at 5.3% and trending lower, it’s not saying much to say that if the economy does well over this year and next – as many now expect - taking lending rates back to average levels will quickly be deemed insufficient: the RBA would push lending rates well past average or “neutral” towards a restrictive policy stance.

How high might the cash rate need to go? Well, recall that it was increased to 7.25% in 2008, before the global credit crunch collapsed local and global growth. Subtract around one percentage point to accommodate the subsequent rise in bank lending margins, and a similarly tight policy stance might involve the cash rate at 6-6.5%.

And what would it take to convince the RBA that the economy needs to be restrained again with particularly tight monetary policy? Probably a touch less than last time around.

As discussed here recently, the RBA’s post-mortem of the 2007-08 “overheating” episode boils down to an observation that the 83-85% boom-time readings on the NAB’s capacity measure simply were “too high”; similarly, 4-4.5% unemployment seems to have been “too low” for the economy’s own good...

Naturally, the RBA is keen to avoid a re-run of the sort of “overheating” that delivered disturbingly high 4-5% core inflation in 2008. Accordingly, if the economy grows strongly enough to get the economy back to “full employment”, the RBA will step in to stop further above-trend growth.

If not much goes wrong from here, it’s easy to see the RBA hiking from 4% at present to 6-6.5% by the end of next year. In that sort of situation, the RBA would be happy for currency markets to take the A$ substantially higher.


The RBA recently highlighted its view that Australia’s extraordinarily large resources boom – now back at full-throttle again, driven by the rapid rebound of high-growth Asia - has the potential to generate serious wage and price pressures over time.

Deputy Governor Battellino spoke candidly about the particular need for other sectors to make way for the mining boom:

"…the truth is… There’s only so much activity that can take place. And if we want to have all this mining investment and mining output, which is happening, basically the other parts of the economy for the moment have to be restrained somehow because the economy can’t do all these things simultaneously." (see answer to Q5)

That is, not far down the track, the RBA can see a potential need to suppress growth in sectors like retail, homebuilding and tourism to make room for miners to do their thing without the economy overheating. This (healthy) “crowding out” necessarily would involve both higher interest rates and a higher TWI exchange rate.

Put another way, the RBA wants the economy to be hot, but not too hot. It wants the unemployment rate to be low, but not too low. The good news is that unemployment has dropped by 1/2pp in less than six months; the bad news is that – at 5.3% - unemployment already is less than 1pp above what policymakers seem to think is “too low”.

Within two years, all of the economy’s excess capacity – all its capacity for above-trend growth – could be gone. Clearly, if unemployment threatens to trend below its “desired” rate of 4.5-5%, the RBA will get keener over time to slow growth. And keener to put in place monetary policy that is as restrictive as it was in the first half of 2008.

There can be no real precision here, as Australia’s central bankers generally avoid policy based on simple “rules”. But with key variables like GDP, full-time employment, consumption, business investment, exports, imports, commodity prices, share prices and house prices all trending higher, and unemployment trending lower, the RBA’s desire for easy policy – and then neutral policy – must be evaporating fast.

It’s hard to forecast anything with confidence – beyond Tiger Woods playing in the US Masters in April - but it’s easy to think our economy will be strong enough over the next two years to force RBA policy back to a stance that is as restrictive as it was two years ago.

In particular, if Australia’s monthly job reports continue to show strong growth in full-time employment alongside a downtrend in unemployment, the RBA will quickly start to wonder if lending rates need to be increased faster than the once-per-quarter pace it seems to have been advocating recently.

This week, all eyes will be on Thursday’s jobs report. It’s probably a stretch at this stage, but a big rise in full-time jobs and a further drop in unemployment would spark plenty of talk and fears of an April hike.

The RBA’s tightening bias will intensify further if the global economy continues to improve. Friday’s payrolls report suggests that even US employment - “weather adjusted” – might have stopped falling, after an extraordinary large drop of 6% over the past two years. (Weekly jobless claims still near their 2001 peak of 470k are less encouraging.)

Related Posts

. You think there's agreement around the the Reserve Bank board table?

. The worst of the rate rises are behind us?

. Going up. Again. Don't doubt it.