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Rate rise reversal: What the RBA did wrong

A composite image of RBA governor Philip Lowe and Australian cash notes.
RBA governor Philip Lowe said his statements on interest rates were always conditional. (Source: Getty)

The Reserve Bank (RBA) led many Australians to believe it wouldn’t raise rates until 2023 or 2024, then went on a rate-rising spree in 2022.

Now it’s saying it never promised it wouldn't lift rates in 2022. The problem, says the bank, is how its comments were interpreted and that, if we misunderstood, that's our fault.

"I am frequently reminded that many people interpreted our previous communication as a promise, or a commitment, that interest rates wouldn't rise until 2024," said RBA governor Philip Lowe last week, appearing before a parliamentary committee.

"This was despite our statements on interest rates always being conditional on the state of the economy. This conditionality often got lost in the messaging."

Did the RBA really ‘promise’ not to raise rates?

A promise is like this: “I promise not to put on this warm jacket today.”

A conditional statement is like this: “I won't put on the warm jacket today, unless it gets cold.”

Also by Jason Murphy:

The RBA might want you to think these are the only two kinds of statements, and that it only ever made the second kind. That is a false dichotomy: there's a third kind of statement, a conditional statement with odds attached.

What the RBA did is like a meteorologist saying: “I would put on the warm jacket today if it gets cold, but it won't get cold, so I won't need this jacket.”

Let me explain.

Technically, the RBA's statements were always conditional. But they also included forecasts of how likely this condition was.

"We want to see inflation around the middle of the target range ... Our judgement is that this condition for a lift in the cash rate will not be met before 2024," said the governor in September 2021.

The bank repeated statements to that effect regularly throughout 2021. For example, here's a quote from April 2021:

"The board will not increase the cash rate until actual inflation is sustainably within the 2-3 per cent target range.

“For this to occur, wages growth will have to be materially higher than it is currently. This will require significant gains in employment and a return to a tight labour market. The board does not expect these conditions to be met until 2024 at the earliest."

Right now, the RBA would very much like you to forget those forecasts were ever made. And especially forget they were made in such definitive language.

A graph showing the actual cash rate v what the RBA forecast
(Source: supplied)

Our job is to not let the bank get away with that. We need to hold the RBA to account by making sure we remember those forecasts.

It was very confident and very wrong.

The RBA said wages wouldn't rise and inflation wouldn't go up. Of course, it was simplifying the situation by describing the most likely scenario from a range of possible outcomes.

But the central bank doesn't get to wave around the probability distribution now and say: “No, no, we always understood a range of options were possible.”

It communicated a single, simple, confident view of the future. That's why its conditional statement was barely distinguishable from a promise - because its forecast was so definitive.

The cost: Credibility

When the RBA said it didn't expect to raise rates, it drew down on its professional credibility.

The RBA's forecasting record can be grim, as the next chart shows. It can miss a lot, so perhaps it’s on us to believe its statements have value.

A graph showing the RBA's wage price index forecasts over the past 20 years.
(Source: supplied)

But, equally, perhaps the governor should bear the forecasting record in mind and express himself with a little more humility.

“The board does not expect these conditions to be met until 2024 … but other scenarios are possible,” Lowe might have said, saving himself a lot of trouble.

“Our judgement is that this condition for a lift in the cash rate is unlikely to be met before 2024," he could have said, acting cautiously.

Russia’s invasion of Ukraine was unexpected, and I would be happy to accept the odds were right if the future had been expressed in terms of odds.

A 90 per cent chance of something happening doesn’t preclude the 10 per cent chance coming to fruition.

I don’t doubt that, inside the RBA, they saw things like that. But the RBA did not express its expectations in terms of odds. It drew a line in the sand, at 2024: “at the earliest”.

Those statements were badly wrong. The professional credibility on which it drew is now spent, exhausted, dissipated.

The same is true, to greater and lesser degrees, among other central banks who also failed to forecast inflation, although the RBA was particularly vehement on the point.

A matter of faith

The RBA talks a lot about credibility. It must make people believe it can and will fight inflation.

If Australians don't believe that, we expect inflation will get out of hand. By virtue of the role of expectations in wage demands, high-inflation expectations can become a self-fulfilling prophecy.

So, how credible is the RBA? By lifting interest rates in 2022, the RBA proves it has the will to fight the enemy. It is not ashamed to fight even when it said it wouldn't have to. That's important and good.

We know it will. But can it?

Willingness is only one aspect of the central bank’s credibility. To be maximally effective, central banks must be credible in many dimensions.

We have to believe monetary-policy tools are effective, and that the RBA knows when to use them.

This last point is the big problem. The RBA has made us believe it does not fully understand the drivers of inflation.

It made big, visible, public forecasts and got them wrong. If it doesn't know when inflation will start, we may conclude it doesn't know when inflation will end.

If it doesn’t understand inflation, this increases the chance the RBA will screw up the next part of its job: stopping interest rate rises at the right time.

Will it stop too soon, letting inflation run away? Or stop too late, successfully capping inflation but killing the economy and ruining the labour market? I don't know.

Its recent performance makes me concerned it doesn't know either.

That matters for the same reasons described above – we need to believe it can and will control inflation in order for inflation expectations to stay in check.

Of course, even a stopped clock is right twice a day, so perhaps the RBA will get this one right - even without understanding why.

That would be extremely welcome in helping restore its credibility. We may hope.

Like logs on a fire

The World Bank has been warning central banks that if they all hike interest rates at once, the synchronised tightening could drive the world into recession.

There is one reason to fear the RBA could fall into that trap domestically: what it does now doesn't take effect until 2023.

Interest rate hikes take a long time to work. The RBA said its actions from here on would be determined by incoming data. This worries me.

If the RBA is looking for evidence it has done enough, it won't see it yet. Not only because data is backward-looking - often collecting information from before rates went up - and not necessarily because it hasn't done enough.

It’s because what it has done so far hasn't taken effect.

Permit me another analogy: Raising rates is like adding a log to the fire. If you wait only 10 seconds to see if the room temperature increases, you haven’t waited long enough to see whether it has worked.

If you then add several more large logs to the fire, you could easily overshoot and end up sweating. By which point it’s too late. You can’t unburn the logs.

Reasons the interest rate hikes haven't taken full effect:

  • It takes 2-3 months for rate hikes to hit family budgets, because banks have to give mortgage holders a notice period before the start of their next monthly repayment period

  • 35 per cent of Aussie mortgages are now on fixed interest rates, not variable. Households will only feel the hit to their disposable income once the fixed-rate period expires

  • If the exchange rate rises, it takes a while for price falls on imports to come through to consumer prices (while our dollar is weaker against the US - and that gets a lot of press - it is stronger against our major trading partners, so most imports should be getting cheaper)

  • Research suggests interest rate hikes take effect over 12-18 months.

This risk of overshooting is why the Commonwealth Bank forecasts the RBA to cut rates twice in 2023.

It would be an embarrassing reversal. But the RBA will make it even more embarrassing if it forecasts it won’t happen.

Let’s hope it’s learned its lesson and refrains from making such strong statements in future.

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