RBA risks confusing markets with mixed economic signals

The Reserve Bank of Australia seems to have lost its policy bearings.

No wonder given the mixed signals it is getting from data and developments inside its own economy, let alone that of the rest of the world.

Unreliable jobs data at home, a persistent housing bubble, a slowdown in China, weakening commodity prices, a very patchy recovery in G7 economies and anaemic world trade growth is not a helpful backdrop to policy making.

Especially for a central bank that is all too keenly aware of the latest warnings from the International Monetary Fund that record low interest rates in the world's major central banks are fuelling excessive risk taking behaviour.

The RBA has been laying the groundwork for a hike from its record low cash rate of 2.5 per cent for quite some time, wanting to steer policy back to better equilibrium with economic growth that has been in a strong upward cycle for several years thanks to the boom in the resources and mining sectors.

The markets have definitely taken the hint - forecasters generally expect higher borrowing costs to kick in around Q1.

The problem for the RBA is that the commodity boom has begun to cool - far more quickly than had been expected - while the spillover effects to the domestic economy, particularly in property prices, are still building steadily.

Hopes for stronger global economic revival have caught a bad chill. 

The Australian dollar - typically a very good gauge of global economic sentiment and risk appetite – has lost its mojo. 

But it is not just worries about slower world trade, weaker commodity prices and falling stock markets that have dented the Australian dollar in recent weeks. Currency markets may be awaking to the possibility that higher Aussie interest rates is not the safe one-way bet that it is supposed to be.

The downturn in global economic prospects opens up a new thread in the interest rate debate. Australia’s record low official cash rate might not only end up stuck at 2.5 percent for a lot longer than previously thought. But, in a worst case scenario, another RBA rate cut could be in the offing if the global downturn suddenly takes a turn for the worse.

That's bad news for investors paying closer attention to recent IMF warnings about over-easy G7 monetary policies leading to excessive risk-taking and credit expansion – possibly sowing the seeds for another financial meltdown in the process.

But the prospect of slower growth in China has a direct bearing on Australia’s growth outlook and on the RBA’s interest rate considerations too – not least because over 35 per cent of Australia’s exports go to China. If China suffers anything close to a bumpy landing, Australia would feel fall-out in a major way, forcing the RBA’s hand into easier policy.

This makes it much harder for the RBA to find its true bearings and get rates headed in the right direction over the coming months. The RBA needs to find the right balance between rising external risks while meeting domestic needs at the same time. This is being made doubly difficult by some of the mixed messages coming out from the Australian economy right now.

Australia’s housing boom continues to be a thorn in the RBA’s side. House price inflation in metropolitan areas is running close to 10% and recently as high as 14.3% in Sydney. Ultra-low borrowing costs are clearly feeding the speculative frenzy, but the RBA has recently intimated that lending controls might be the better option than using the spike of higher rates to pop the bubble.

Employment conditions are sending oblique signals on rates as well. Where labour market data may be providing clearer policy signals for central banks like the US Fed and the Bank of England, in Australia, recent employment trends have been just plain confusing, thanks to hefty back revisions in the jobs numbers.

It is leaving the markets with a sense that the RBA is ‘flying blind’ on rates for the time being. October’s policy statement reaffirmed the RBA’s commitment to keeping ‘a period of stability in interest rates’.

But the RBA needs to be very careful about the message that it is relaying on stable rates, especially while dropping hints that the Australian dollar ‘remains high by high by historical standards’. Aussie dollar bears will soon start to scent blood.

If global economic conditions take a further dive and the RBA starts to wobble the Australian dollar will soon start to tumble.

Reprinted courtesy of South China Morning Post  13 October 2014