Does it really matter if the RBA cuts rates tomorrow or not?
It seems inevitable the Reserve Bank of Australia will drop the cash rate in its meeting this week, and possibly again later in the year. Some are now also suggesting a third cut is also likely by the end of the year to help kick start our slowing economy.
The May 2019 RBA Board minutes suggests the markets have already priced in two rate cuts; even using this bond market data the RBA forecasts are still only getting moderate GDP growth, unemployment rate is staying sticky at 5 percent and inflation is remaining soft; and given these outcomes, the RBA Board might believe it may as well drop the cash rate next month as it won’t cause the economy to overheat in the short to medium term.
Prior to the last month’s meeting I was advocating the RBA Board hold off reducing the cash rate for a variety of reasons, including the fact that KPMG’s analysis shows monetary policy is less effective in stimulating the economy when the cash rate is below 2 percent compared to when it is above this level.
This fact, added to the growing level of global economic uncertainty which is being driven by rising geo-political risks, including, but not limited to, the US-China Trade War, Venezuela, Brexit, and Chinese debt, means that the RBA should keep its monetary policy powder dry until it really, really needs to use it.
Clearly those issues haven’t changed in the past 30 days; although some of the geo-political risks have become more pronounced.
Regardless of my interpretation of the last set of minutes, if I am asked the question today “Should the RBA Board cut the cash rate in its next meeting?” my answer would be “It doesn’t really matter. Sort of. Well, at least not in the next month or so”.
Clear enough answer. Remember, I am an economist.
The reason for this response is because in pricing debt the bond market has currently assumed the RBA will at some stage – and sooner rather than later – validate its view that monetary policy will be used to actively stimulate the economy. And it will do this by cutting the cash rate by 50 bps over the next six months.
We’re seeing this in both short dated bonds and swaps, and longer dated bonds. The 1-month, 3-month and 6-month Overnight Indexed Swap rates have all fallen during May to now be 1.30 percent, 1.17 percent and 1.07 percent respectively, while 2-year bonds are 1.11 percent and 10-year bonds are below 1.50 percent. These already low and falling rates will feed through to the retail lending market, and we’ve already seen this with some banks offering 5-year fixed mortgages rates for less than 4.5 percent per annum.
So while the RBA decision is important, it’s really only important in the sense that a reduction in the cash rate by the Board is a validation exercise in that it acknowledges the bond market has correctly priced in the need for some form of stimulatory action to help lift the performance of the domestic economy.
If the RBA agrees with the market’s assessment we think it makes sense to cut rates by 50bp – if they are going to use their powder they may as well make it count as much as possible at these already low rates. In some sense cutting rates by 25bp at the next meeting is neither here nor there. If the RBA remains uncertain about the need for rate cuts because the labour market data continues to provide mixed signals then they can afford to wait for additional evidence and move more decisively if required. The lower yields currently priced into the bond market will provide a cushion if it turns out that any new information supports a reduction in rates.
The Board may have been more cautious about cutting the cash rate at the next meeting – regardless of how the bond market was pricing money – given expectations of a Labor Government, which had an agenda of increased spending. But with that not happening there is more of an argument to use some of our limited monetary policy firepower; but it should be a decisive move.
Nonetheless, the reality is that a drop in the cash rate to 1.00 percent in June will have a limited effect on increasing GDP in next financial year or the year after. KPMG modelling shows that a 50bp drop in the cash rate in June will only increase real GDP by less than 0.1 percent in FY20, and by about 0.1 percent in FY21, compared to the scenario of the cash rate staying at 1.50 percent until the end of 2021 and then increasing back to normal monetary policy settings.
Most of that increase is in the form of higher household consumption expenditure, followed by business investment and housing investment. This result isn’t because household consumption is more responsive than investment activity to monetary policy adjustments; rather it’s simply because consumption makes up a larger proportion of economic activity.
So, it doesn’t really matter whether or not the RBA drops the cash rate next week. The market has already priced in a lower cost of funds, which should find its way to the retail borrower at some stage; and our analysis shows the net impact on real GDP of a 50bp cut in the cash rate is small anyway.
But where the RBA decision does matter is in the signal it gives to the market, to the politicians and to the community at large, that the Australian economy is not firing on all cylinders, and as one of the guardians of national welfare, the RBA is looking to help out where it can.