Interest rate move RBA risks 'already fragile' credibility with: 'Cut, rise or hold?'

The level of interest rates set by the RBA today will influence economic conditions over a 12 month period. (Source: AAP/Getty)

Along with house prices, and probably because of that, Australians have a deep interest, obsession even, with interest rate settings. Will interest rates go up? Down? When? By how much?

When is the next RBA meeting (18 June)? What do the retail sales or unemployment data mean for interest rates? It’s never-ending.

Inevitably and at any time, there is a wide range of opinions on these issues with the more extreme commentary most likely to get the attention of the media even if there is little genuine prospect for those ‘crazy cat’ forecasts coming to fruition.

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Having looked at how the RBA has functioned over the past 35 years, I am still learning how best to look at the question of the appropriate level for interest rates.

It is clear that those running the RBA are in the same position. This is especially the case when the economic news in recent years has delivered a cocktail of news no one has experienced in their working life: the unemployment rate at a 48-year low, inflation at a 32-year high, interest rates at an all-time low and massive money printing from central banks around the world.

Good luck working out how to bring balance back to the economy with that scorecard!

A good approach to interest rate settings – aim for errors

Let’s have a look at the here and now and the changes that are or at least should be driving RBA considerations of interest rates.

Given that the level of interest rates set by the RBA today will influence economic conditions over a 12-month period, each of the eight times the RBA meets each year, its key focus is – and should be – where it thinks the key elements of the economy will most likely be this time next year.

Based on that assessment, it should judge whether the current level of interest rates is more likely than not to be appropriate for that outlook or at the very least, which way those forecasts are most likely to be wrong and in which direction.

As things stand ahead of the RBA announcement next week, the latest data shows:

• Annual GDP growth slowing to 1.1 per cent

• Unemployment rate rising to 4.1 per cent

• Inflation easing to 3.6 per cent

• Wages growth clearly peaking at around 4 per cent.

• Cash rate is 4.35 per cent

This time next year, it is close to certain that GDP growth will NOT be 1.1 per cent, the unemployment rate will NOT be 4.1 per cent, inflation will NOT be 3.6 per cent and wages growth will NOT be 4 per cent.

Given what we know about the momentum in these variables, which direction will they change – that is, higher or lower – and what would the RBA least like to see if it decides next week to hold the cash rate at 4.35 per cent are critical considerations.

In other words, what weight or probability is GDP growth likely to be above or below 1.1 per cent and unemployment above or below 4.1 per cent, inflation above or below 3.6 per cent and wages growth above or below 4 per cent?

First: Get the probability of the directional change. Based on what we know now about the economy, here are the risks:

• GDP growth: it’s 50:50 growth will be higher / lower in a year’s time.

• Unemployment rate: it’s 90:10 the unemployment rate will be higher / lower.

• Inflation: it’s 10:90 inflation will be higher / lower.

• Wages growth: it’s 30:70 wages growth will be higher / lower.

The ‘central’ expectation is for ongoing sluggish growth, rising unemployment, lower inflation and a modest dip in wage growth. These are in fact the latest RBA forecasts.

Second: Orders of magnitude matter too. This is where the judgement calls, rather than hard and fast forecasts, are important and feed into the RBA deliberations. What would the RBA prefer to see this time next year?

With restrictive interest rates, which are in place now, unemployment is likely to be materially higher and inflation materially lower. Too high and too low for the sake of the economy are the risks.

In a scenario planning exercise, if the RBA were to cut interest rates 25 basis points next week and at the meeting after that, which is no one’s expectation by the way, how does that risk assessment change?

Unemployment would rise a little less – it would still rise - and the fall in inflation would be more moderate – it would still fall.

By holding interest rates too high for too long, the RBA risks a spike in unemployment, costing many tens of thousands of jobs and for inflation to fall too far.

If it holds rates steady next week, the RBA is telling the population it is will to risk these outcomes which will risk its credibility at a time when it is already fragile.

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