Why the RBA was wrong not to cut rates: Kohler

The Reserve Bank is focusing on the superficial rather than the authentic – that is, on the market’s irrational exuberance and not the real economy.

The decision to hold off on further rate cuts was explicitly based almost entirely on market action, not on economic data.

True, US Federal Reserve chairman Ben Bernanke supported the sanguine stance of the RBA this morning in his testimony to congress. However, he is saying that from the vantage point of a zero to 0.25% Fed funds rate; he has done all he can with rates and is now printing money. And even then he is still forecasting “sizeable” further job losses.

With its own cash rate target at 3%, the RBA has definitely not done all it can, yet it seems – in words if not actions – to be gloomier than the Fed.

Here are a few snippets from Governor Glenn Stevens’s statement:

• “The global economy contracted further during the first few months of this year.”
• “…the near-term outlook remains weak…”
• “The Australian economy contracted in the latter part of 2008, and this has continued in 2009 to date…”
• “Capacity utilisation…will decline further over the rest of the year.”
• “…confidence remains fragile…”
• “With demand for labour weakening, growth in labour costs will probably also fall.”
• “Business borrowing…is declining.”

So why not cut rates again, given all this gloom? Because, according to the RBA Governor, credit spreads have declined, equity prices have firmed, and borrowing for housing is picking up (because of first home buyer demand).

Since when has monetary policy been set according to the current mood in financial markets? They will only ever lead you up the garden path, and this time is no exception.

Markets are now diverging wildly from the real world. Equity prices are running well ahead of any likelihood of an improvement in earnings; bond yields have barely reacted to perhaps the greatest deterioration in government budgets ever seen; oil prices have galloped to nearly $US55 a barrel despite falling global demand and rising inventories.

Investors are simply in a positive frame of mind – it’s time to buy. Markets have had an amphetamine injection from governments and central banks and are babbling wide-eyed and wired, looking through the gloom, anticipating recovery. In this mood there are nothing but shoots of green.

That’s what markets do, especially when they have had such a massive injection of liquidity. At some point, probably quite soon, they will return to utter despair as a result of some unforeseen trigger, and all the news will be bad once more.

But it’s disappointing that the central bank has fallen into the mood swings of Mr Market as well.

The main thing yesterday’s interest rate decision will do is lift the currency to further heights of over-valuation because of the very large interest differential between Australia and the rest of the world, and make life even more difficult for local manufacturers and resource exporters than they already are.

This article first appeared in Business Spectator