Since 1990, there have been five cycles of interest rate cuts in Australia. The last four were after 1993, when the Reserve Bank of Australia (RBA) adopted a target of 2 to 3 per cent annual inflation.
The decision to start a cycle of interest rate cuts is always momentous for the RBA. It takes the step of initiating a monetary policy easing cycle when it is confident that inflation is expected to be in the target range and there is a serious risk of rising unemployment.
All this is simple and quite obvious.
Or is that it?
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Despite snorting from some loud and wildly misplaced commentators that the next move in interest rates will be up, investors are banking on interest rate cuts over the next 12 to 18 months, not hikes.
The reasons for this investor confidence are quite simple. The current inflation rate will continue to fall as depressed economic growth, rising unemployment, slowing wage growth and global economic conditions continue to impact price pressures.
For some, there is a feeling that the RBA will need inflation to fall further before cutting interest rates.
This view ignores history and, indeed, ignores how the RBA previously operated when managing its dual objectives of low inflation and full employment.
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RBA lags behind interest rate cut curve
It is well known and very obvious that changes in interest rates take many months to fully impact economic activity and inflation. The well-established view is that a change in the interest rate today will take between six and 18 months to take full effect. This is a calendar that the RBA knows well and on which it should act.
Which brings us back to the start of past interest rate cut cycles.
The following table shows something that defies conventional wisdom, as facts often do. Implicitly, it shows that the RBA is about to make a big policy mistake by keeping interest rates too high in the face of moribund GDP growth and rising unemployment.
Some basic facts:
At the beginning of each interest rate cut cycle (with the possible exception of February 2001, which was distorted by the price effects of the introduction and extension of the goods and services tax), inflation has been above of 3 percent.
At the same time, the unemployment rate remained stable or decreased when rates were first reduced.
Furthermore, the GDP growth rate has been strong and clearly has not been an impediment to cutting rates.
As the data stands right now, annual inflation sits at 3.6 percent, not far from levels at the start of previous rate cut cycles. At the same time, the unemployment rate is 0.5 percentage points higher today than it was a year ago, which is in stark contrast to the situation in any other cycle.
What’s more, GDP growth is currently disastrously weak, below the growth rate recorded at the start of any other rate cut cycle.
|
Date of first interest rate cut |
Inflation % y/y at the time of decision |
Change in unemployment rate in the previous 12 months |
GDP growth% change year-on-year |
|
January 1990 |
7.8%# |
-0.7 percentage points |
5.6% |
|
July 1996 |
3.1% |
-0.1 percentage points |
4.4% |
|
February 2001 |
5.8% * |
-0.7 percentage points |
3.3% |
|
September 2008 |
4.4% |
-0.3 percentage points |
2.9% |
|
November 2011 |
3.4% |
-0.1 percentage points |
2.5% |
|
To be decided – latest data |
3.6% |
+0.4 percentage points |
1.1% |
#Before the introduction of the 2-3% inflation target.
*Inflation increased by approximately 3 percentage points due to the introduction of the GST.
A question arises: why is the RBA so reluctant to consider an interest rate cut just as the data is flowing and, more importantly, the risks say it should be cut?
The RBA’s rhetoric
The RBA is avoiding interest rate cuts because of one issue: its perceptions on inflation.
He is practically ignoring rising unemployment with this kind of verbiage in his most recent Monetary Policy Decision:
We’ll see that, particularly with the fact that wage growth is already slowing in the wake of the weakness in the economy and the already seen rise in unemployment.
The decline in GDP growth barely received a mention in the RBA’s latest statement: there was a lame comment that “output growth has been moderate and per capita consumption has been declining”, without any reference to how serious it was. weakness, with annual GDP growth of just 1.1 percent, and what this meant for future trends in unemployment and inflation.
The RBA also noted on inflation: “The process of returning inflation to target is unlikely to be smooth” and “the persistence of services price inflation is a key uncertainty.”
In other words, the RBA has little confidence that its inflation forecasts are correct, even though it is using its inflation analysis to not cut interest rates.
So why wait to cut interest rates if inflation could be lower than currently forecast?
Ultimately, it is clear that the RBA is breaking with tradition and, curiously, is scared by the time it takes for inflation to return to target. This is despite the indisputable facts that economic growth and the change in the unemployment rate are consistent with inflation returning to target very soon and, more importantly, inflation is MUCH lower than you have predicted. the RBA over the past year.
The mistake the RBA is making by keeping interest rates too high for too long is propping up a further rise in unemployment with further weakness in economic conditions.
It is unlikely to end well.
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