MNI ANALYSIS: RBA Guidance May Need A Nod To Downside Risks

By Sophia Rodrigues

     SYDNEY (MNI) - Downside risks to the Australian economy are growing and

unless the Reserve Bank of Australia changes its forward guidance, it runs the

risk of misguiding or making incorrect policy choices -- if forward guidance is

indeed a policy tool.

     The RBA's current policy guidance doesn't sufficiently capture growing

risks that the cash rate may have to be lowered below 1.5%, and unless this

changes, there is a risk that the guidance will be considered no more than noise

at best and a policy mistake at worst.

     That could, however, change if the RBA converts a line from the minutes of

the last board meeting -- "Members noted that there were risks to the forecasts

in both direction" -- into guidance signalling clearly there is enough, if not

equal, risk that the next move in the cash rate could be lower.

     --GROWING RISKS

     The main downside risk is a further tightening in lending standards, at a

time when wage growth remains subdued, house prices are softening and the

outlook for gradual decline in the jobless rate remains hazy. This would affect

household borrowing and spending, hurting the economy's growth and inflation

prospects.

     In recent years, central banks have been making greater use of forward

guidance as a policy tool in an attempt to provide certainty about the path of

monetary policy.

     Forward guidance by its nature is fraught with risks, so getting it right

is as good as getting a policy tool right and vice-versa. But the central bank

must get its initial message correct, and more importantly, to evolve that

message as the macroeconomic situation changes.

--COMMUNICATION ERROR

     One communication error happened late last year when Governor Philip Lowe

said if the economy continues to improve as expected, it is more likely that the

next move in interest rates will be up, rather than down.

     Even though there were two key stabilisers to the guidance -- "if the

economy continues to improve" and "more likely" -- they were lost in the noise

of the RBA suggesting interest rates are likely headed higher.

     Lowe strengthened guidance further in March, seen as a clearer signal that

the rate cut door was closed tight. That may have still been a good strategy if

it were not for the RBA adding that "the board does not see a strong case for a

near-term adjustment in monetary policy."

     For many in the market, that signalled that even though an RBA hike was not

imminent, it was not too far off.

     Guidance on both direction and timing are in stark contrast to the RBA's

updated economic forecasts published earlier this month, which suggest a rate

hike may be a long way off.

     Downside risks have increased since the May meet, to the extent that not

only does a hike look a long way off, there is now a chance the RBA may have to

lower the cash rate.

--POLICY GUIDES

     Guidance must also help steer the economy towards the policy goals and not

work against it. In hindsight, Lowe's guidance may have done exactly that.

     Earlier on Lowe's watch, RBA language said it was keeping open the option

of cutting the cash rate below 1.5%. That changed in July 2017 when he first

used the word "patient", citing a buoyant labour market -- a signal to financial

markets that the rate cut option was being taken off the table.

     Looking back, the message on patience may also have been a mistake, as it

implied the RBA wasn't serious about its inflation goal, even though it has

always been intent on getting inflation back to the mid-point of the 2% to 3%

target band. The RBA's message may have inadvertently had a dampening impact on

wage growth, despite an acceleration in wages being important to reaching the

inflation goal.

     So important is wage growth to the policy goal, that Lowe even admitted

that talking about the benefits of stronger wage growth to put a floor under

wage expectations was one of his strategies.

--MNI London Bureau; tel: +44 203-586-2225; email: les.commons@marketnews.com

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