The Reserve Bank of Australia’s overnight cash rate has been unchanged at a record low of 1.50% for a record 28-months (Fig 1a). Throughout 2018, the central bank’s meeting minutes and speeches suggested that rates remained appropriate – implying a broadly neutral policy stance – while hinting that the next rate movement would be higher, albeit with “no strong case for a near term adjustment in monetary policy”.
For the majority of 2018, forwards markets agreed with the central bank and were firmly pricing in future RBA rate hikes – but this has abruptly changed (Fig 1b) with the market now indicating a 50/50 chance of a rate cut in 2019. This rapid reversal could exert substantial influence on the central banks thinking with significant implications for money market and fixed income investors.
Stuttering growth engines:
Historically, Australia twin engine economy has been a source of strength, with the combination of commodity exports and domestic demand helping the country avoid recession for a record breaking 27-years. In the past half-decade, as mining infrastructure investment waned, a booming housing market – with prices jumping by 45% between 2012 and 2017 – replaced it as the key driver of economic growth.
However, the factors that triggered the housing surge – low interest rates, easy bank financing, limited supply and strong foreign demand have recently faded due to a combination of new macro prudential measures, higher commercial bank mortgage rates and tighter restrictions on foreign buyers. House prices (Fig 2a), building permits and new home sales have all fallen sharply, with negative repercussions for retail sales and consumer confidence.
Meanwhile, the well-publicized slowdown in Chinese economic growth and rising global trade tensions have raised the specter of lower demand for key Australian commodity exports including coal, gas and iron ore.
Consequences and conundrums:
Throughout 2018, solid business sentiment, an improvement in capital expenditure intentions and a tight labor market – with strong hiring momentum and up-tick in wage price pressures – encouraged the central bank’s belief that inflation would move higher – implying the need for future rate hikes.
But weaker housing, sharply lower business sentiment and softer domestic demand are already impacting growth and are challenging the viability of the RBA’s optimistic 3.5% 2019 GDP forecast. The hawkish bias is also being questioned as the RBA has never hiked interest rates during a housing market downturn (fig 2b).
The path of least resistance:
Economic growth will likely slow in 2019, albeit from a previously robust level. However, fears of a property price crash are likely overdone: Low unemployment and low interest rates suggest mortgage payments remain affordable and most homeowners still enjoy positive equity. Little mortgage borrowing was completed at the peak which was perceived by many as unsustainable.
Finally, even if the economy slowed faster than expected, the RBA has capacity to cut base rates if necessary and the government’s improved fiscal position has given it the ability to cut taxes or boost spending if required.
Given this backdrop, the RBA is likely to strike a more neutral tone in meeting minutes and revise down its 2019 GDP forecast while keeping base rates unchanged for the foreseeable future – further extending its record breaking period of inertia.
 RBA’s December monetary policy meeting minutes as at 18th Dec 2018
 Source: RBA Statement On Monetary Policy, 9th Nov 2018
Following the Fed’s announcement, please see below for market views from the Global Fixed Income, Currency & Commodities Team (GFICC):
Consistent with our and the market’s expectations, the Federal Open Market Committee (FOMC) maintained the Fed Funds rate target range of 2.25% ‐ 2.50%.
The January FOMC statement was notably altered in order to reflect the Committee’s commitment toward data-dependence and bias towards patience in regards to additional rate hikes. Despite viewing a strong labor market and sustained economic expansion as the most likely outcome, the Committee removed the balance of risks to the outlook from the statement given the reduced visibility around the US and global economy due to “cross-current” described in detail below.
Although the official statement did not reference the balance sheet normalization process, the Committee released an additional document on balance sheet normalization which indicated the Committee’s desire to continue to use interest rate policy as their primary tool but with flexibility available to adjust balance sheet policy in the future within the context of maintaining the current floor system of ample reserves. For now, the decline in the Fed’s asset holdings will continue in the background at the max run-down rate (30bln Treasuries / 20bln MBS).
Overall, this was a decidedly more dovish statement than market participants had expected.
We can break the statement into two parts:
There were no dissenters.
Chair’s Press Conference
Chair Powell remained somewhat upbeat on the US economy, specifically the labor market, but recognized the continued “cross-currents” which included policy uncertainty (trade and Brexit), the weakening global growth backdrop and the impacts of the government shutdown. He recognized the contradiction between the still robust economic data in the US and the cross currents described below and stated the best way to manage risk in this situation was to be patient and take a “wait and see” approach. Chair Powell also described the case for raising rates to have diminished due to muted inflation risks.
On the balance sheet, Powell stated that the Fed is actively working towards a decision on when to conclude the balance sheet run-off given that the balance sheet will need to be larger than it was pre-crisis. In addition, he reiterated the details of a separate document released with the statement which emphasized that interest rate policy would remain a primary tool but balance sheet policy was not on a pre-set course and ultimately the run-down in the balance sheet will be within the context of an abundant reserve regime.
The chairman struggled to explain the rather abrupt shift in the tone of communication that appeared to move even further beyond the assurance he provided the market during his January 4th comments at the American Economic Association (AEA). Powell cited persistently tighter financial conditions and a continuing narrative around weaker global growth as reasons for the shift. However, it was challenging to view the cumulative changes in the communication post at the December FOMC meeting as being anything other than reactive to financial markets. It remains to be seen whether today’s press conference performance represents a material shift away from the current hiking cycle or indeed a true pause before the cycle continues.
All eight FOMC meetings will be followed by a Press Conference this year.