RBA: Reaction function is not fixed in time - ANZ

Research Team at ANZ explains that the RBA’s reaction function is not fixed in time as ANZ finds that the RBA is now especially sensitive to below-target inflation outcomes and at the same time the RBA’s sensitivity to shifts in the unemployment rate has declined. 

Key Quotes

“This seems quite reasonable to us. The risk of embedding excessively low inflation outcomes has motivated aggressive policy responses by many central banks in the postGFC period. We think the policy implication is that the RBA needs to see clear evidence that core inflation is trending sustainably higher before it even considers raising interest rates. A premature tightening of monetary policy may result in even lower inflation outcomes that will have negative feedback implications for wages, among other things.”

“Our model can be adapted to determine a point estimate for the RBA cash rate. Based on our forecasts for inflation and unemployment the model points to a rise in the cash rate at the end of 2018. The distribution of possible outcomes is skewed to the downside, however. In the near-term there is a greater likelihood of a cut than a hike. We think the best way to capture the combination of the central point estimate with the skewed risk distribution is to forecast no change in the RBA cash rate over the forecast horizon.” 

“Further evolution of the RBA’s reaction function seems more likely than not, though always within the constraints imposed by the RBA’s mandated objectives. This needs to be kept in mind when forecasting the likely policy path for the RBA.”