Opinion: Risk of RBA Policy Error from Distorted Money Market Signal

By Sophia Rodrigues

Australia’s money market is currently placing too much weight on the Reserve Bank’s comments and not enough on assessing economic data. This is distorting the signals it is sending to the policymaker and unless the RBA disentangles its reflection from the signal, it runs the risk of making a policy error.

It is a well known fact that there is a circular relationship between the market and the central bank, with both relying on each other for guidance on action.

Monetary policy influences market prices, and also relies on the same market prices.

This circular relationship can work well if market puts enough focus on economic fundamentals and relies on its own judgement, while also listening to central bank communication. But many a times market participants are too eager to anticipate the next policy move and assign a large weight to the central bank’s utterances, and less to the economic data.

If the central bank follows this signal it may inadvertently make a policy move based on a market  signal which was in reality its own signal. In rare instances, the problem is compounded by the fact that the market misreads the central bank’s signal in the first place.

This is exactly what may be happening in the Australian money market currently.

The consumer price index inflation for the third quarter, due in about a week’s time, is expected to show a soft outcome, with core inflation well below the RBA’s 2% to 3% target band.

Leading indicators for the labor market point to a moderation in employment growth. GDP growth was softer than expected in the second quarter,  though some expect it will return to trend growth next year.

Amid this backdrop, no one expects the economy to reach full employment in the next two years and possibly more, and there is no expectation that inflation will reach the middle of the target band during this period.

In such a scenario, it would not be unrealistic for market to price in a decent possibility of another cut in the cash rate in November given the RBA’s updated forecasts would be screaming another cut. The possibility would be greater because the RBA has explicitly dismissed the argument that some monetary stimulus should be kept in reserve to address any future shocks.

However, the market is pricing in less than 25% chance of a 25 basis point cut in November because the pricing is based more on its interpretation of RBA’s comments and less on data, and their likely path.

While the RBA knows how to disentangle its own communication from the signal, there is still a risk it may react to its own reflection.

Last week at an IMF event, Governor Philip Lowe was asked a question on whether he thinks the RBA has still a lot of work to do in terms of delivering monetary policy easing given they are well short of their targets.

Lowe gave an answer that any central banker in his place would have given. He said, “I don’t think it’s the right assumption to make that we’re going to have a lot more work to do to get inflation back to target and growth back to trend. It’s possible but I wouldn’t assume it.”

The emphasis in both the question and the answer was on “lot of work to do” and yet Lowe’s answer has been taken to mean the RBA was talking down more rate cuts.

Lowe didn’t dismiss possibility of rate cuts, including possibility of near-term rate cut.

At the same event, Lowe also talked about how we are now in a world of diminishing returns to monetary easing, and how the main effect of lower interest rates is on asset prices. He also said that he is feeling uncomfortable about the prospect of the combination of subdued economic growth and asset prices.

However, those comments aren’t too different from what Lowe said at another international event back in August --Jackson Hole Symposium.

And in any case, the RBA said in the minutes of October board meeting that asset prices are part of the transmission mechanism of policy. It is no secret that the RBA is relying on higher housing prices to boost consumption, and equally importantly, to boost home building.

Lowe’s comments cannot thus be taken to mean the RBA is currently worried about rising house prices now, and that worry would stop them from lowering the cash rate in the near term.

How can RBA be worried about rising housing prices when it is relying on the gains to encourage housing construction?

Consider this analogy with Lowe’s comments about macro-prudential policy. Lowe said that to offset the effect of low interest rates with macro-prudential instruments, which basically limit borrowing, seems to be working against the effect of low interest rates.

--Email: sophia@centralbankintel.com