The minutes of the February Board meeting indicate that the Board discussed a rate cut due to the slow expected progress in achieving its objectives. However it highlighted its discussion around the risk/rewards of lower rates. The housing market and its impact on credit represents the key risk.
The minutes of the February Reserve Bank Board meeting do not provide much further information than we have seen from other communication from the Reserve Bank in recent weeks including the Governor’s speech to the National Press Club; the Statement on Monetary Policy; and the Parliamentary testimony.
Key to the policy outlook is the final section of the minutes which notes: “Members reviewed the case for a further reduction in the cash rate at the present meeting. This case rested largely on the only gradual progress towards the Bank’s inflation and unemployment goals.” To date of course the word “gradual” is generous given that over the last year the trimmed mean inflation rate has remained around 1.6%yr with the unemployment rate stuck above 5%. We understand that the Bank’s inflation and unemployment goals are for trimmed mean inflation around 2.5%yr and the unemployment rate (current estimate of full employment) at 4.5%.
The minutes point out that policy was eased significantly last year with the cash rate coming down from 1.50% to 0.75% and emphasised that there are “long and variable lags in the transmission of monetary policy”. However the Bank’s own forecasts which were released with the Statement on Monetary Policy on February 7 indicate that the unemployment rate will only fall to 4.8% by June 2022 and the trimmed mean inflation rate will only reach 2% by that time.
Consequently the Bank is accepting that under the current policy settings (and these forecasts assume another cash rate cut which is priced into the market) it will not achieve its inflation and unemployment goals by mid-2022. It may be implying that a gradual move towards these goals is ‘good enough’ but does highlight the risks of any set-backs in this process for policy. In that regard lead indicators around job vacancies and job ads are not encouraging.
The question arises therefore as to why the Board decided not to take further policy action. After all, these minutes and other communications emphasise that monetary policy remains effective, working through the exchange rate; household cash flow; and housing market channels.
The answer to that question lies in the concept of “risks associated with very low interest rates”. The Board refers to the impact of very low interest rates on resources allocation and on the confidence of people in the community, notably those reliant on savings to finance their consumption. Furthermore, and arguably of most importance, is the concern that low interest rates could encourage additional borrowing at a time when there was already a strong upswing in the housing market.
The Board will be aware that housing credit growth is currently at its lowest level (3.1%yr) in the history of the housing credit series. Reasonable assumptions about a strong pick up in new lending for housing are still only consistent with a lift in housing credit growth from around 3%yr to 4%yr in 2020. Consequently the “additional borrowing” argument seems unconvincing.
On the other hand the real issue is likely to be around the unexpectedly rapid increase in house prices across the nation. With house prices already near or above previous highs in some areas (Melbourne; Brisbane; and Adelaide are either above or just slightly below previous peaks) affordability constraints may start to slow the pace of increase unless demand from investors, who have been remarkably restrained in this cycle, starts to gather momentum.
If that is the case then the Board risks the classic challenge of having too many targets and only one instrument. It may be that in time it will recognise the difficulty of that situation and re-target monetary policy at its core objectives of employment and inflation. As we saw in 2015 and 2017 when concerns arose with frothy housing markets, largely driven by investor activity, the authorities successfully addressed that issue with macro prudential policies.
On the international front the minutes noted the coronavirus outbreak as a “new source of uncertainty” and members observed that it was “too early to determine the extent to which growth in China would be affected or the nature of international spill overs”. With the Board noting the expected short term nature of the shock it is likely that a Board that is emphasising the “long and variable lags” of monetary policy would be reluctant to respond to the virus effects with an ‘insurance cut’.
Finally it is important to note that there was a general discussion at the meeting around “the operation of macroeconomic policy and monetary policy frameworks in an environment where interest rates are low because of structural factors”. Issues for discussion were cases for and against aggressive easing when rates are near the lower bound; inflation targets; and fiscal policy.
Conclusion
The meeting discussed a further reduction in interest rates because prospects are for only gradual progress towards the Bank’s inflation and unemployment goals.
The decision to defer hinged largely around the benefits vs the risks of lower rates.
Those risks were around encouraging additional borrowing in the housing market. With housing credit growth benign and little evidence of loose lending practices it seems reasonable that any evidence that the gradual convergence towards the inflation and employment targets is not being achieved will result in further policy easing.
That profile remains Westpac’s view although we recognise that this evidence may take more time to emerge than implied by our current forecast that the next cut in rates will be at the April Board meeting.
