The reason why the RBA isn’t prepared to cut rates lies within a speech that Philip Lowe gave 2 years ago

• Australian inflation is weak. Very weak. Especially underlying inflation, the preferred measure of gauging price pressures among policymakers at the Reserve Bank of Australia.
• During his tenure as RBA governor so far, Philip Lowe has never achieved his inflation mandate.
• In his first speech as governor, Lowe made the case for allowing inflation to miss target temporarily in certain circumstances.
• Lowe also provided a big hint as to what may prompt the RBA to react to continued undershoots on inflation.

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Australian inflation is weak. Very weak. Especially underlying inflation, the preferred measure of gauging price pressures among policymakers at the Reserve Bank of Australia (RBA).

In the year to September it grew by a paltry 1.75%, according to data from the ABS, the eleventh quarter in a row that it undershot the RBA’s 2-3% inflation target.

The year-ended reading is now actually moving away from the bank’s target.

With the inflationary pulse in the economy cooling, it’s easy to understand why some are calling for the RBA to cut official interest rates again.

Indeed, in the September quarter alone, underlying CPI grew by just 0.32%, the weakest result since early 2016. Back then, such was the scale of the weakness, it prompted the RBA to cut rates twice within three months, firstly in May and again in August, leaving the cash rate at the level it sits today at 1.5%.

Given inflation is moving away from target yet again, and with the domestic housing weak and signs the global economy may have already moved past its cyclical peak, why not cut interest rates again?

The RBA is, after all, not fulfilling its policy mandate — a polite way of saying it’s not doing its job.

However, after the RBA last cut rates in August 2016, something changed one month later: Philip Lowe became RBA Govenor, replacing Glenn Stevens as the head of the central bank.

Ever since Lowe took over, inflation has been low, sitting below the RBA’s target.

However, unlike his predecessor who often moved interest rates following the release of an inflation report, Lowe hasn’t adopted that mindset, seemingly content to let inflation continually undershoot quarter after quarter without an adjustment in policy.

But why?

Lowe gave plenty of clues as to why he’s not rushing to cut rates in his first speech delivered as governor, appropriately entitled “Inflation and Monetary Policy”.

“To be clear, our core objective is to deliver a rate of inflation that averages between 2 and 3% over time. But we want to do that in a way that best serves the public interest,” Lowe said.

“When we find ourselves with inflation that is either lower, or higher, than normal, we want to feel confident that, over time, inflation will return to more normal levels.

“There is, however, always a choice about the exact path we take.

“When thinking about that choice, developments in the labour market and in balance sheets in the economy have particular importance.”

Read that last line again carefully.

It explains the lack of reaction function from the RBA to weak inflationary pressures since Lowe took over.

While getting inflation back to within target remains the RBA’s core objective, it’s not only the target that needs to be considered.

Lowe elaborated why.

“Achieving the quickest return of inflation back to 2.5% would be unlikely to be in the public interest if it came at the cost of a weakening of balance sheets and an unsustainable build-up of leverage in response to historically low interest rates,” he said.

Taking on more and more debt, put simply.

Lowe made his views crystal clear in early 2017, telling the House of Representatives Standing Committee on Economics that further rate cuts “would probably push up house prices a bit more, because most of the borrowing would be borrowing for housing”.

“Household debt is at record levels. Is it really in the national interest to get a little bit more employment in the short term at the expense of encouraging that fragility,” Lowe asked policymakers.

Financial stability, as it has become known, is something that Lowe clearly deems to to be important when it comes to monetary policy deliberations.

Given the track record in recent years, one could easily argue that it has surpbaded returning inflation to target as the key policy objective, seeing the bank keep policy steady in an attempt to slow, then reverse, the increase in household leverage seen over prior decades.

Even with home prices now falling in many parts of the country, and with housing credit growth slowing as a result of prior tightening of macroprudential restrictions by APRA, the RBA still appears to be reluctant to cut interest rates again. It is concerned that such a move, while helping to boost inflation, could lead to households piling on even more debt, potentially creating even greater problems than a mild undershoot in inflation further down the line.

Even with the introduction of macrprodential restrictions, and the subsequent success they’ve had in slowing the housing market, the RBA appears to have little faith it will remain that way if the cash rate is cut again.

It simply isn’t interested in cutting rates again unless it really has to, at least based on recent public statements.

So what could get the RBA to change tune when it comes to the next move in the cash rate?

Lowe also provided a big clue in maiden speech as governor.

“The case for moving more quickly would be strengthened in a world where the labour market was deteriorating and people were having increasing difficulty finding jobs,” he said.

That’s clearly not the case at present.

Unemployment sits at a six-year low of 5% and employment growth remains firm, running faster than the increase in Australia’s labour force.

If that were to change, it could prompt the RBA to venture where it’s been reluctant to go recently, particularly as it would do little to improve confidence that inflation would return to target over time, the other caveat Lowe nominated for keeping policy steady during periods such as this.

Based on the latest forecasts offered back in August, the bank appeared confident that labour market conditions would gradually tighten further on the back of strong and above-trend economic growth this year and next, helping to push underlying inflation back to within target — but not to the bank’s midpoint of 2.5% — by the end of 2020.

So, the two preconditions for a rate cut have not been met: labour market conditions are expected to improve and inflation to gradually increase.

Until that changes, and despite not meeting its inflation mandate, it’s likely the RBA will see the next move in the cash rate as up.

With inflation already weak, the labour market holds the key as to what will happen next, at least from a domestic perspective.

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