Is Oz Flirting with Forward Guidance?

The Reserve Bank of Australia must be feeling pressure to provide financial markets with explicit forward guidance on the long-term direction of its interest rate strategy. These days, with central banks all over the world providing markets with forward guidance on rates in an effort to shape market expectations, the RBA is one of the few remaining major central banks to maintain a sense of anticipation at each meeting – rates could just as easily go up as they could go down. Even the European Central Bank has finally backed away from its sacred no “pre-commitment” policy. Check out my previous post on forward guidance here.

Increasingly these days, what was once considered to be “abnormal,” markets are beginning to construe as “normal.” A central bank that doesn’t provide forward guidance is increasingly seen as hawkish (“do they have something to hide?”) and markets tend to react by driving up its bond yields and their respective currency – effectively tightening financial conditions.

Indeed, until just a few days ago, the Australian dollar had stopped weakening and their falling bond yields have failed to fall further. Markets had even been pricing in rate hikes in 2014 – that’s increasingly at odds with the Australian economic outlook, but an opinion that wasn’t explicitly rejected by the RBA.

Certainly, the Australian economy seems to need easier monetary conditions. Recent data on business conditions, consumer confidence, job vacancies/advertisements, and retail sales have all pointed to the risk that the recovery may be faltering. In addition, household income dynamics remain under continued pressure. Building approvals data fell almost 7% in June alone, while home construction activity has simply refused to respond sufficiently to the encouraging signs of lift in the leading indicators like prices and auction clearance rates.

The unemployment rate rose in June to its highest level since September 2009. Admittedly, at 5.7%, the labour market hardly appears to be in a dire situation (the governors of the Federal Reserve, the Bank of England, and the European Central Bank would probably dislocate their shoulders patting themselves on the back if they could get their respective unemployment rates so low). But, Australia’s current unemployment rate is higher than its structural unemployment rate, and is continuing to drift steadily higher. Second-quarter CPI inflation also surprised to the downside. The RBA’s favoured underlying measure of inflation, the provocative-sounding trimmed mean, came in at 2.2% year-on-year, suggesting that inflation has decelerated further into the lower half of the RBA’s 2%-to-3% target band.

And so it was that the RBA (tentatively) appeared to respond to these pressures at a speech on 30 July, titled “Economic Policy after the Booms.” RBA Governor Glenn Stephens noted that the inflation data enabled the RBA to retain its scope to ease, and acknowledged the weakness of the domestic economy. He went a step further by pointing out that the resource investment drop that Australia would likely suffer as a result of the “policymaker-desired” slowdown in China would create a challenging time for the Australian economy.

Remember that Australia was the largest developed nation to avoid a recession during the financial crisis. It achieved this by cutting interest rates aggressively, easing fiscal policy, and by increasing exports to China – in the past five years, those exports have almost quadrupled. However, that dependence could now become a liability. With the China-led resources boom effectively over, Australia is vulnerable.

Governor Stephens said that the RBA was not especially concerned with running out of ammunition and that it was not near the zero-bound of monetary policy. While he didn’t provide explicit forward guidance, his comments suggest interest rates will remain low throughout 2014 – a significant departure from previous comments that have suggested that the RBA never pre-commits. While this may not be a confirmed sighting of forward guidance, we’re definitely seeing its shadow.

He also noted that the “normal” level for interest rates isn’t what it’s been in the past. When reflecting on households’ post-crisis caution towards debt, the Governor noted “interest rates are likely to be lower in such a world… This is a global phenomenon, but it holds in Australia too.”

Financial markets have now calculated a 74% probability of an August rate cut, and are applying more pressure on the RBA to provide not only forward guidance, but also (gasp) quantitative easing.

One step at a time we say. Although the RBA’s charter clearly offers it operational flexibility should more abnormal policy be required and there are no obvious restrictions on balance sheet measures that would involve purchases of assets, the Australian economy isn’t quite in need of such desperate measures. Well, it isn’t quite in need just yet. A hard landing in China could change all that.


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