Waiting for the Dust from the Election to Settle

With the federal election only five days away and the cash rate having been cut to a historical low last month, the dominant approach for the Shadow Board members is to wait and see what the election will bring.

The outlook for the global economy has not changed appreciably from last month. With the Federal Reserve in the US is looking for an exit from QE3, there exists a growing concern about the possible implications of rising world interest rates and reversals in international capital flows, particularly for some of the developing nations in the Asia Pacific region.

Domestically, previous interest rate cuts are slowly feeding through the economy, buoying the real estate market and depreciating the Australian dollar. However, the longer it takes for low interest rates to stimulate the real economy, the greater the risk that easy money will lead to inflated asset prices and to financial trouble in the future.

After the RBA’s decision to cut the cash rate to 2.5% last month, the Shadow Board’s preference for keeping the cash rate unchanged is strong: the nine members are 65% confident that holding steady is the appropriate policy. Members are only 13% confident that a further reduction of the cash rate by 25 basis points is warranted, while a 22% probability is attached to the need for a higher current rate.

There is more uncertainty about the appropriate policy setting at longer horizons: the probability that rates will need to rise in the next six months is about 41%, while the probability that rates ought to be lower than the current rate has increased to 32%. A year out, the shadow board members attach a 52% probability to the need for an increase in the cash rate and approximately a 31% probability to the need for a decrease in the cash rate.