The RBA - Speaking loudly but carrying a small stick

Until the Reserve Bank released its Statement on Monetary Policy last month I was, like most economists, predicting no change for interest rates in the next few months. Since then, almost all of us have got on board the vehicle traditionally chosen by Australian pundits for effecting rapid 180 degree changes in direction - the bandwagon.

Largely because of the Bank’s change of heart, rates have risen. But predicting rate rises is different to saying we should have them. Bond traders, who are no strangers to “groupthink” and the herd behaviour that goes with it, are surprisingly sceptical. Lots of them think a rate hike is a mistake, even though they expected it.

Having said as recently as November that there was "no pressing need" for interest rate rises, the Reserve said a couple of weeks ago that it has been debating rate rises internally, that until then it had desisted “on balance”, but that another rate rise was likely in future.

Since then, a range of new indicators have emerged which make the Bank’s job - which cannot be done successfully without a fully functioning crystal ball - even more difficult.

You see the problem is that one set of data - the national accounts which calculates all the payments made in the economy says growth has nearly halved - from nearly 4 per cent to about 2 per cent. But the growth in the number of jobs is running at around 3 per cent per annum. Given that productivity grows at around 2 per cent per year that suggests growth around 5 per cent.

So as Rory Robertson from Macquarie Bank says, quoting Chris Caton in late 80s. “If you you’re not confused, you don’t know what’s going on”.

Further anecdotal evidence suggests looming skills shortages (lucky we cut back on education, training and research and development assistance). And the chasm between what we pay foreigners - in interest, loans and money for imports - and what they pay us for the same things is yawning ever wider. When Paul Keating famously warned of our becoming a banana republic this deficit was around 6 per cent of our economy. Last quarter it was over 7 per cent. What kind of republic does that make us now - a banana fritter republic maybe? Our economy is at serious risk of going squishy.

These numbers make further rate rises more likely - though the better policy would be a larger budget surplus and or a reordering of government spending priorities away from election bribes and towards more investment in skills, infrastructure and better incentives to move from welfare to work.

While I’m not convinced the Bank is right, they’ve got some of the best people and a great record (at least since some disastrous calls a decade and a half ago that helped give us the recession we had to have).

I’d still offer the following caution.

US President Theodore Roosevelt practiced a brand of diplomacy he called speaking softly but carrying a big stick. The Bank is doing the converse. It's speaking loudly so it can use the smallest stick it can get away with.

The Bank will raise rates as little as it thinks is necessary because it will be acutely aware of the problem higher rates (and the resulting higher exchange rate) pose for exporters who we desperately need to thrive right now. In the past, the Bank has “jawboned” as much as it could to restrain the economy - and usually market commentators do a good job of “overshooting”. They overestimate the extent of the tightening course the RBA is on. They leave people with the impression that rates could go up a lot further than they usually do.

So whereas the “no rises” scenario was unlikely, I don’t agree with most economists that there will necessarily be several rate rises or as ANZ’s chief economist Saul Eslake puts it “interest rate changes are (as the Americans say) like cockroaches - there’s never just one of them”.

This might be the way the Bank is thinking now. But remember that, because of the size of people’s mortgages, the last time rates were increased by just 0.25 per cent they had an immediate and larger effect than expected. I think something similar will happen again and that this will buy the Bank time. A second rate rise may not be necessary.

Against all this, you can try two strategies to protect your own mortgage - “fix the rate” or “pass the parcel”.

Normally you pay for fixing - as it’s a form of insurance against a rate rise. But markets are sometimes slow to react to emerging news. Right now, for no particular reason Queensland lenders offer some of the best value in fixed rates. One leads the national market with a special of 6.49 per cent - that’s around basic variable rates locked in for three years which is pretty enticing. Another offers 6.6 per cent with complete flexibility - enabling additional repayments and redraws whenever you want.

You can also stay variable and play “pass the parcel”. Competition continues to push lenders’ margins down. Chances are you can charge a fair bit of any interest rate rise to lenders, by switching to a similarly featured loan at a lower rate.

One thing is for certain, we don’t really know what’s happening. Everyone is guessing. And economists don’t have a good record of picking the “turning points” of economic cycles. Maybe we’re at one right now.