The Reserve Bank faces another highly anticipated interest rate decision on April 1.
Its decision to lower the cash rate by 0.25 percentage points in February to 4.1 per cent was expected, but it has been revealed it was a very close call.
RBA chief economist Sarah Hunter has used a speech to explain the decision-making process the board undertakes to arrive at a decision.
“Today, I want to shine a light on three key inputs to the process, how they interact with one another and how they fit together to support the board in its decision-making,” she told the AFR Banking Summit.
Dr Hunter said, primarily, the bank wanted to understand how an interest rate decision would affect the economy.
“This necessitates a forward-looking approach to meeting our mandate,” the RBA’s assistant governor for economics said.
“Policy decisions require both a view of the outlook for the economy and an understanding of how policy is likely to affect that outlook.
“That helps the board set the cash rate to give the best chance of achieving the RBA’s objectives over time.”
Dr Sarah Hunter has outlined the RBA’s decision-making process. (ABC News: John Gunn)
Months-long lags in full interest rate effects
The RBA needs to do this because, as Dr Hunter explains later in her speech, the bank’s modelling shows that it takes nine months for a rate move to have its biggest effect on economic growth.
It takes around twice that long for it to have its peak effect on inflation.
The central bank’s key mandate is to keep inflation between 2-3 per cent while maintaining the lowest level of unemployment compatible with that first goal — what many economists euphemistically term “full employment”.
Naturally, the lag between rate moves and their effect on the economy puts a heavy emphasis on the bank’s ability to forecast economic growth.
“The implication of continuously updating our view on the outlook means we also continuously update our policy advice to the board.
“The future pathway for the cash rate is not predefined,”
Dr Hunter said.
But there is one word that has come up more often than usual in most documentation the Reserve Bank has produced recently: uncertainty.
The chief economist felt it appropriate to highlight that.
“In practice, we are uncertain about both the outlook for the economy and the effect of monetary policy, and this complicates policy decisions,” she told the summit in Sydney.
“Under uncertainty, policy depends on more than just the central forecast — judgements about the risks and uncertainties matter too.
“That’s why, as we have discussed on a number of occasions recently, it’s important to consider alternative possible pathways for the economy and how policy would have to respond.”
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US economic policy key source of uncertainty
A key uncertainty for both the Australian economy and the Reserve Bank’s decision-making process, notes Sarah Hunter, is US economic policy.
“Board decisions are always made in an uncertain environment, which means thinking about the distribution of risks around the central forecast,” she said.
“One of the things we are focused on right now is US policy settings, the impact of these on the global economy and how this flows through to activity and inflation here in Australia: we have been using scenarios, analysis and judgement to assess the policy implications.”
It turns out Macquarie Bank has been doing similar analysis.
In its latest client note, which is not publicly available, Macquarie Bank warns Donald Trump’s economic policies run the risk of precipitating a stock market crash.
“Unless Trump blinks and pulls back from trade wars and spending cuts, which currently seems unlikely, there is risk of a material slowing in US real consumer spending,” Macquarie analysts warned.
“As this is the most consistent signal of a bear, we see growing risk that stocks fall 20 per cent from their Valentine’s Day peak.“
The benchmark US S&P 500 stock index is already down almost 8 per cent from its highs last month, with the tech-heavy Nasdaq almost 12 per cent off the peak it reached in December last year.
US economy shows worrying signs
Recent US economic data has reinforced these concerns.
A University of Michigan survey revealed on Friday that consumer sentiment plummeted 11 per cent in March and has now dropped 22 per cent since December.
Consumers also revised up their inflation expectations over the next 12 months and five years.
Worries about a major economic downturn in America have also ramped up since President Donald Trump refused to rule out a recession.
AMP’s head of investment strategy Shane Oliver is also concerned the world’s biggest economy is about to stumble, sending financial markets down with it.
“The past week saw Trump’s 25 per cent tariffs on all steel and aluminium imports to the US start as scheduled with no exemptions,” Dr Oliver wrote.
“This in turn saw the global trade war ramp up with the EU and Canada announcing retaliatory tariffs, Trump threatening a 200 per cent tariff on EU wine and briefly pushing up the tariff on Canada to 50 per cent after Ontario briefly imposed a 25 per cent tax on electricity exports to the US.”
Dr Oliver noted that another key test for the Trump administration’s determination to push ahead with its tariff plans was coming up in the next fortnight.
“There is a long way to go though, with 2nd April shaping up as the big day: with exemptions scheduled to be removed from some of the tariffs on Canada and Mexico along with the start of “reciprocal tariffs” presumably on all countries and tariffs on various industries including semiconductors, autos, pharmaceuticals, copper and agriculture,” he observed.
“Trying to make sense of this and work out the endpoint remains difficult with Trump at times focused on redressing the rest of the world ‘ripping us off’ in some way and at other times seeking to bring production back to the US.
“But there is now a real risk that after April 2, average US tariffs will have risen to levels around or maybe even higher than they were after the Smoot-Hawley tariffs of 1930.
“These famously contributed to the severity of the Great Depression as other countries retaliated and global trade collapsed.”
Shane Oliver said there was a real risk the Australian share market could fall 15 per cent or more over the coming months.
Interest rate cut timeline uncertain
Yesterday, Treasurer Jim Chalmers warned ex-Tropical Cycle Alfred would put further pressure on the federal budget and lift prices for agricultural products.
The obvious implication being that this could potentially delay the next RBA interest rate cut, although the central bank tends to look through short-term one-off price effects.
But veteran budget watcher Chris Richardson said risks around what the Reserve Bank would do next centred on the “chaos in the US”.
“And that could go either way,” he told The Business
“President Trump is pushing up prices and expectations around inflation with what he’s doing with tariffs.
“But there is a fair amount of chaos there and that is weighing on economic growth.
“So what the Trump administration is doing is both adding to and subtracting from inflation.
“My guess is that, from the viewpoint of Australia, those actions over in the US probably make it a little more likely that we get the next cut rather than less likely. But, even then, not until May.“
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Most economists agree that better-than-expected first-quarter ABS inflation data could give the Reserve Bank ample evidence to cut the cash rate again, but that information will not be released until April 30, well after the next RBA board meeting on April 1.
