Two TEACHable moments
Last week’s RBA decision and Trump’s recent tariff escalation both highlight the need to take organisational dynamics and human psychology into account.
- While there was nothing economically to be gained by the RBA waiting to cut rates, neither was there any material policy cost. Psychological and organisational factors therefore might have come into play, with the RBA taking the opportunity to assert some independence.
- Not paying enough attention to these psychological issues was a mistake, and thus a learning opportunity.
- Psychological factors are also at play in global tariff negotiations. If people think you will chicken out, you set out to prove them wrong. Asserting dominance is another psychological factor at work in the international sphere. This complicates analysis and prediction, but economic fundamentals still matter as well.
Try, Even After Catching Heat
Since last week’s surprising RBA Monetary Policy Board meeting, countless pixels have been spilt trying to understand the central bank’s rationale. There was no real economic benefit to waiting five more weeks. This week’s labour force data would not have tipped a decision to cut in August back to a decision to hold, even if the data had not shown the softening in employment and kick up in the unemployment rate in the month.
The third month of CPI data will also not add much new information to support a continuing hold. Recall that even with a partial monthly CPI indicator, once the second month of the quarter is in, you already have two-thirds of the ultimate quarterly read. This is true no matter how much of the index is measured monthly. Two out of three months of the data measured monthly are available and so are two-thirds of the components that are only measured in one of the three months in the quarter, assuming these are evenly distributed across the three months. (This is why the Governor’s comment that the monthly inflation data was ‘a little too volatile and not quite representative of what’s really going on with inflation’ misses the mark. It is a true statement about the headline monthly indicator, but that is not how people are using the data.)
Neither was there much of a cost to waiting, though. As we have previously noted, the dirty little secret of monetary policy is that small differences in the level of interest rates or the timing of changes make essentially no difference for inflation outcomes. If holding the cash rate 100bp lower for a year only boosts inflation by 0.2%pt or so – broadly the result from the RBA’s main model – then 25bp higher for five weeks is not even a rounding error.
It’s a natural human temptation to want to minimise error. After all, we did warn that a cut in July was not a shoo-in, and three of the nine Board members voted against the decision, and presumably in favour of a cut. But we must face into those wrong calls and own them if we are to learn from them. The lesson here is to keep trying to understand, even after a wrong prediction.
Firstly, I underestimated how much we humans can get stuck in a narrative. It was one thing to push back on a market that was focused on the ‘but they discussed 50bps!’ argument and an apparent downward revision to views of the neutral rate. It was quite another to believe that the RBA would keep clinging to the idea that inflation was too high because one very lagged (but important) measure was at 2.9%. Our own assessment, based on more recent data, was that the current pulse of trimmed mean inflation is closer to the midpoint of the 2–3% target range than that. Perhaps because we were so clear on our own view of the inflation pulse, I underweighted the possibility that the RBA would stick to a different view despite the latest monthly data. Put another way, I overweighted what I thought the RBA should do over what I suspected they would do.
Secondly, I underestimated the psychological element. We knew that the RBA is not the Fed in terms of its comfort with surprising the market. And it has become clear that the RBA Governors would regard it as pre-empting the Monetary Policy Board to guide the market ahead of a meeting and a decision being made; this is one of the drawbacks of having a majority of outside members on a committee making a market-sensitive technical decision.
More importantly, though, I should have given some weight to the idea that the RBA insiders might use a relatively costless (from a policy perspective) five-week wait to signal the institution’s independence. The last thing a central bank wants is to be seen as not independent, including from the markets. Cutting the cash rate in July, rather than the RBA’s original preference for a ‘cautious and predictable’ quarterly pace coinciding with fresh forecasts, would have looked a bit like the market pricing forced the cut. Avoiding that impression was probably viewed inside the RBA as being worth the subsequent criticism.
Trump Escalates And Causes Havoc
A similar ‘you’re not the boss of me’ instinct can be seen in recent US tariff developments.
Much has been made of the ‘Trump Always Chickens Out’ idea, first mooted by Rob Armstrong of the FT ‘Unhedged’ newsletter. Perhaps, though, it would have been better framed as ‘Trump Ambit Claims Often’ – a description of a negotiating strategy rather than the suggestion of a character flaw. Because once the idea began to circulate, it was natural human psychology – not even specific to President Trump – to want to prove it wrong.
Thus we see the US administration not only not chickening out, but in some cases escalating its tariff demands. In many cases this is a negotiating tactic to get countries to offer further concessions or reach a deal at all. The administration may also have been emboldened by the sanguine response of financial markets to recent developments, as well as the relatively muted effect evident in recent US inflation data. Meanwhile, countries that have reached a deal have achieved a lower US tariff rate than was originally announced in April.
Another element of this recent escalation is continuing the dominance display that these tariffs always represented. They are as much about showing the world who is boss – or, as the White House itself put it, “Keeping America in the Driver’s Seat” – as about actual economic policy goals.
Economic fundamentals still apply. The tariffs are still an act of inflationary self-harm, so the default presumption should be that re-escalations are negotiating tactics, not the likely end state. And to the extent that specific goods are not already produced in the United States, relative tariffs will matter as well as absolute tariff levels. Countries facing a 10% or 20% tariff should therefore not feel too despondent about it.
That said, we are more in the realm of psychology than economics and must proceed accordingly. While de-escalation from ambit claims is still the likely outcome for most countries, temporary blow-ups cannot be ruled out. A lot will depend on other governments striking the right balance between belligerence and obsequiousness. Governments and outside observers alike will need to pay attention to the psychology – and learn from their own and others’ past errors.
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