As Reserve Bank Board members return from their holiday break, they will be confronting a momentous decision – whether to reduce the cash rate for the first time in more than four years at their February meeting.
Despite the private sector recording zero growth in the September quarter last year, the Board decided against reducing the cash rate at its December meeting. While the tone of the Board’s media statement and minutes was more confident that a cash-rate reduction might be imminent, the Reserve Bank’s separate November statement on monetary policy forecasts the unemployment rate to increase gradually “before stabilising around full employment” of 4½ per cent around the end of 2025.
Despite repeated acknowledgements by Reserve Bank officials in the past year that the Non-Accelerating Inflation Rate of Unemployment – the NAIRU – is now less than the Bank’s earlier estimate of 4½ per cent, the November statement on monetary policy expressly puts it at 4½ per cent.
This is against the backdrop of the most recent wage price index showing annual wages growth had fallen to 3.5 per cent in the September quarter from 4.1 per cent in the June quarter, as wages growth slowed on the back of a cooling economy.
Indeed, the minutes of the Reserve Bank Board’s December meeting reported that wages growth had slowed faster than expected, adding to confidence that inflation was on track to return to its 2-3 per cent target range.
Turning to prices, when measuring inflationary pressures the Reserve Bank doesn’t focus on the headline inflation rate but on the so-called trimmed mean rate. This measure removes the 15 per cent fastest-growing prices and the 15 per cent slowest-growing prices from the headline rate.
The idea is to take out temporary price shocks such as floods and temporary government subsidies.
The Financial Review’s John Kehoe argues that there are so many federal and state subsidies that not all of them will be trimmed out, artificially suppressing the trimmed mean rate.
He goes on to argue that if the quarterly trimmed mean inflation rate due out on 29 January comes in as forecast at 0.7 per cent, or less, the Reserve Bank Board will be under massive political and community pressure to cut the cash rate at its 18 February meeting before a federal election.
Coincidentally, two macroeconomists with experience at the Reserve Bank have also stated that if the trimmed mean inflation rate for the December quarter comes in at 0.7 per cent or less, the Reserve Bank Board will be obliged to cut the cash rate at its 18 February meeting.
Those arguing for keeping the cash rate higher for longer claim that cutting it would be political, but it would be political not to cut when the case to do so was so strong.
Traders are pricing in a 59 per cent chance of a February cash-rate reduction and are certain it will happen by April, the Board’s second meeting this year.
But Reserve Bank staff might take the opportunity to argue that the trimmed mean inflation rate has been artificially suppressed by government subsidies, so the Board should ignore the December quarter number and keep the cash rate on hold. That would be consistent with pushing the unemployment rate up to their 4½ per cent estimated NAIRU.
Yet the actual inflation rate announced on the Reserve Bank's website is now within the designated target range of 2-3 per cent, a rare occurrence in the past decade.
This is the inflation rate that Australian consumers and businesses feel, that shapes inflationary expectations, and which is carried directly into future prices by formal and informal indexation arrangements.
The Reserve Bank board looks also at the trimmed mean, which may also fall within the target range before long. If die-hard opponents of cutting the cash rate within the Reserve Bank’s economics department are now arguing that the trimmed mean measure itself needs modification, then, as Alice remarked, life is getting curioser and curioser.
Also curious is the date for the Reserve Bank board’s next meeting. By selecting 18 February, the Reserve Bank Board will be meeting just one day before the releases of the all-important wage-price index on 19 February and the labour force data on 20 February.
These are crucial indicators of the existence or otherwise of a wage-price spiral, which is the Board’s main concern and for which there has been no evidence to date.
It might seem easy, with this curious timing, for the Board to make further encouraging noises following its 18 February meeting, while keeping the cash rate on hold in accordance with the advice of those in the economics department who seek to lift the unemployment rate to 4½ per cent in conformity with their models.
But with the private-sector economy already having slowed to a halt, a Board decision at its February meeting to delay cutting the cash rate would put it into reverse gear.
If the Reserve Bank Board closely examined leading economic indicators, relied less on macroeconomic models built on economic behaviour in earlier times, and abandoned the goal of lifting unemployment to 4½ per cent, it would be in a strong position to make the right decisions on the cash rate at its February meeting.
Craig Emerson is managing director of Emerson Economics. He is director of the APEC Study Centre at RMIT University, a visiting fellow at the ANU and adjunct professor at Victoria University’s Centre of Policy Studies.