Interview: Why the Reserve Bank doesn't want to cut interest rates

Published Aug 6, 2024, 6:30 PM

Yesterday the Reserve Bank left interest rates on hold, and dashed hopes of a cut anytime soon.

Westpac Chief Economist Luci Ellis - formerly RBA Assistant Governor - talks to Sean Aylmer about why the RBA board remains so focused on bringing inflation down, even as central banks elsewhere in the world begin to cut rates.

Welcome to the Fear and Greed Business Interview. I'm Sean Almam. Yesterday afternoon the Reserve Bank Board left interest rates on whole at four point three five percent and we may not see a cut anytime soon. With inflation remaining a persistent challenge for the bank. I'm joined today to talk about it by Westpac's chief economist, Lucy Ellis. As I've mentioned before, Lucy has a unique insight into the way the Reserve Bank processes this information and makes decisions, having been the Assistant Governor at the Reserve Bank until late last year, effectively the chief economist, Lucy. Welcome back to Fear and Greed.

Thanks very much, Sean. Great to be here.

What do you make of yesterday's decision and statement with it and commentary by Michelle Bullock at the press conference afterwards.

Broadly, we weren't surprised by their decision to hold. We weren't surprised by the inflation numbers that came out the previous week. We were only a little bit surprised about the trim me, whereas the market was more surprised, and indeed our inflation outlook for trim mean is almost identical to what the Reserve Bank published in its statement on monetary policy yesterday. What is a little puzzling is their view about how long they think they need to keep interest rates steady from here. They are still worried about upside risk to inflation. They have a very particular view about goods inflation. And while we always expected the RBA to be among the laster to cut, if not the last, because they didn't go up as far, they don't have as far to go. The RBA does seem to now be constructing a view of their reaction function, which says that you don't start reducing the restrictiveness of policy until we are very very close to target. Now we know policy operates with a lag. We know that you actually have to start reducing the restrictiveness of policy before getting back to target. And that consideration didn't really feature in any of their communication yesterday.

Michelle Bullock, the governor, came out and said there were two options on the table. One was to lift rates, the other one was to hold rates, knowing that they would be on hold for a while. Is that in your experience and you've worked inside the bank. Obviously surprising that they didn't at least consider when a cut might be necessary.

The board are really conscious that things are uncertain, and they always have been, so they don't generally prejudge where they're going to be in three or six months time. And in the periods where they have wanted to give more forward guidance, that hasn't worked out so well, and so you know, the governor has been very reluctant to provide any kind of forward guidance. Recently, we expected that the choice would be between a rate hike and keeping rates on hold. But our view was that with inflation coming down on the track that the RBA has been forecasting for quite some time, I mean, the inflation forecasts are almost the same as where they were in November, so your view of the policy shouldn't be that different. What seems to have changed, though, is that but since May, they've changed their view about the level of demand and the level of supply. They've revised their view about aggregate demand up, and they've revised their view about supply capacity and in particular productivity down. We're still assessing why they've come to that conclusion. It's not one that we necessarily share, but that does seem to be entering into their thinking. But it is very common for a Reserve bank board to consider two different cases, even if they're not seriously considering one of them. In this instance, they given how recently the inflation numbers have turned around. Of course they were considering whether to hype rates, but it just isn't something that we think you will actually transpire because they're also conscious that, you know, the level of rates where they are is causing a lot of pain in the community. So as long as inflation remains on track, you know, they'll have to remain vigilant, they'll have to keep the retrick very robust, but ultimately they're going to be in a position down the track that they can say, Okay, we're close enough to target that we can start removing the restrictiveness of policy. They we won't be in a hurry to do that, and they're clearly in less of a hurry than we would have expected, but you know that's the profile that they're looking at.

Stay with me, Lucy, we'll be back in a minute. I'm speaking to Lucy Ellis, Group chief economist at Westpac. Just help me understand the aggregate demand comment you just made. Ben the Reserve Bank in their statement yesterday certainly sounded more optimistic about agricate demand. If that's a way of putting it, then, I thought, particularly given the cost of living crisis, the pressure people are under agricate demand is all of demand, as the name suggests. Is that because there's too much government spending? Is that because actually households are as poorly off as we thought? Just unpack that aggregric demand comment for me.

Well, it does take quite some unpacking, as just as we can tell, there are two main changes driving their assessment. One is that there is more government spending than they had in their forecast previously. The other is that they have pushed out their population growth profile. So Westpac Economics is one of the few outfits that actually puts out a projection for population growth over the near term independently of government. We've been expecting that population growth would be around that one point nine to two point zero rate four twenty twenty four for a while. In its May forecast, the RBA had a slower rate of population growth this year. They expected that rollover after the surge in population when the border is opened to happen faster than it's actually happening. So they've moved their population growth forecast to be more in line with what we already had, and so that's increased their view of overall growth in the near term. The overall level. Now, if you're adding more people, you're adding more demand, but you're also adding more supply. So the other piece of the puzzle, in addition to the public demand that they're seeing, is also that they have downgraded their forecast for productivity growth. This is a long standing uncertainty after the pandemic. Our own view at Westpac Economics is that productivity growth is rolling over because the slump in productivity was, in our view, a ripple effect from OD and it just will take some time to wash out. But the Reserve Bank's taken a more bearish and more pessimistic view of how quickly that can turn around than we have.

So what's your best estimate about when the Reserve Bank will move on interest rates?

Well, up until yesterday afternoon, we were expecting rates to be you know that the Reserve Bankboard would be in a position to start cutting rates in November. Our forecast for inflation hasn't changed and theirs is in line with ours. So you know, if they had the reaction function we thought they had they would be cutting rates in November, but given the language in the statement on monetary policy, given what the governor said in the media conference, even if things play out as we expect, we just don't see they will see their way through to pivot that quickly. So our forecasts are under review at the moment while we assess the basis for the Reserve Bank's economic outlook.

Lucy, I've got to ask you the question about what it's like inside the Reserve Bank because you have been chief economists, You've been involved in all these discussions, albeit not this year because you're obviously at Westpac chief economs at Westpac. But I mean, is there a lot of two toing and froing going Do you turn up with your forecast? The economics team turned up with their forecasts and there's a lot of debate about it. I'm just kind of interested in the process in those meetings.

Well, without giving inn a thing a way that's not already in the public domain, there's a couple of speeches that go through the process. Glenn Stevens gave one some years ago. Michelle Bullok I think it was gave one as Deputy Governor, where she talks through the process and the timing. Now some of those things have changed since I left because of the recommendations of the Reserve Bank Review. The Board now meets over two days, So instead of squishing all the discussion into three hours on a Tuesday morning, they have both the Monday afternoon and the Tuesday Mollie. They have a lot more inter meeting interaction with the Board than used to be the case, and so there is an opportunity to kind of test and shape the view about what their artlook looks like. But what essentially I think is going on here is it's not so much about how they've tested the forecasts. As I said, their forecast of trim mean or almost identical to ours. Now that they've revised their forecasts in the most recent statement on monetary policy, what has changed is they've become less forward looking. And so what has changed with the Reserve Bank Review recommendations is they are now much more focused on this idea of the level of aggurate demand versus the level of aggregate supply, and that's sort of a framework that they didn't rely on as heavily in the past.

Fascinating LISSI, thank you very much for talking to Fear and Greed.

Thanks very much, Sean's great great as always.

That was Lucy Ellis, Group chief Economist at Westpac. This is Fear and Greed Business Interview. Join us every morning for the full episode of Fear and Greed Daily business years for people who make their own decisions. I'm Sean Eelma Enjoy your day.