MAY 2016 INSIGHTS BY THE CURVE TEAM –

Highlights

  • The RBA cut the cash rate in May to 1.75% taking some economists and commentators by surprise.
  • After leaving the outlook unclear in its accompanying statement, the RBA subsequently downgraded its outlook for inflation in its Quarterly Statement on Monetary Policy.
  • The latest US jobs data did little to help the FOMC make the case to hike rates again in the near term.
  • The lower outlook for inflation and likelihood of further delays from the FOMC continues to suggest risks are skewed to the downside for Australia’s monetary policy setting.

Rates Recap

  • Following a weaker than expected Q1 inflation print, the RBA cut the cash rate 25bp to 1.75%.
  • The decision was a surprise with the market pricing a 50/50 chance of a cut prior to the meeting.
  • In the accompanying statement, Governor Stevens gave little insight into the outlook for the cash rate.
  • The subsequent Quarterly Statement on Monetary Policy from the RBA saw substantial downgrade to the outlook for inflation resulting in a shift in market pricing.
  • The latest US jobs data confirms a slowing of momentum in the US economy, placing pressure on the FOMC’s rate hike plans.
  • As a result, expectations for an FOMC rate hike were pushed to next year which will have ramifications for the RBA and monetary policy in Australia.

All About Inflation

The modern era of monetary policy management by the RBA is driven by a dual mandate of fostering sustainable growth in demand and ensuring outcomes consistent with the inflation target. While the mandate is specific in its dual purpose, its wording gives the RBA a degree of latitude to achieve its goal over the medium term. The RBA takes advantage of this flexibility by using adjustments to the cash rate to achieve its mandate. This is where the outlook is critical as it determines how the RBA will act to achieve its goal.

The RBA indicated its decision to cut the cash rate to an historic low of 1.75% was driven by the change in the outlook for inflation. Its Quarterly Statement on Monetary Policy expanded on the current state of inflation – and more importantly the outlook.

In addressing its reasoning behind the decision to cut rates, the RBA said: After taking account of developments over recent months, the Board’s assessment at its May meeting was that the outlook for economic activity and the unemployment rate was little changed, but that the inflation outlook was lower than earlier anticipated.” 

This was obviously due to the lower than expected inflation reading for the first quarter. While there were temporary factors at play which dragged the figure lower, there was longer term drivers at play which the RBA made particular mention of:

“The data indicate that there has been broad-based weakness in domestic cost pressures, reflecting low wage growth, heightened retail competition, softer conditions in rental and housing construction markets and declines in the cost of business inputs such as fuel and utilities.”

The extent of how much these factors impacted inflationary pressures can be seen in the charts from the Statement on Monetary Policy (see right). It is important to note that while some temporary factors will naturally pass over time, these more enduring factors will take more time to address and influence.

One of the key measures of inflation that would have tipped the RBA towards cutting is non-tradable inflation. Items contained in this series are generally less price elastic – and therefore less impacted by swings in the level of demand.

As can be seen in Chart 5.3, non-tradable inflation has fallen sharply in recent times, highlighting the extent to which demand side pressures on inflation are fading.

As a result of these developments, the RBA summed up its decision by saying: “Taking all of these considerations into account, the Board judged that the prospects for sustainable growth in the economy, with inflation returning to target over time, would be improved by further easing of monetary policy.”

 The key words here are “over time”. The question the market is grappling with is how strong are disinflationary forces and how long will it take for them to abate, allowing inflation to head back up towards the RBA’s 2-3% target band? This is where the RBA’s forecasts and the assumptions around those forecast are of paramount importance in the outlook for interest rates.

Outlook for Interest Rates

This time two weeks ago there were already question marks over the outlook for interest rates, even before the Q1 inflation report was released. There were downside risks to the economy that remained prevalent, which had the RBA closely assessing the incoming data. The inflation report was eventually enough to tip the scales towards a rate cut – however the market was still a little unclear over the outlook for the cash rate.

A closer look at the RBA’s inflation forecasts suggests the outlook for the cash rate could be a little clearer. While the lower starting point for inflation was enough for the cut in May, the forecasts suggest that we could see another rate cut in the months ahead.

Inflation is expected to remain below or at best in the bottom end of the RBA’s target band throughout the forecast period, which stretches out to 2018. Although this is not enough to suggest a rate cut is forthcoming, we know the RBA likes to manage its targets over the medium term.

When taking a close look at the forecasts, particularly at the assumptions behind them, the outlook for the cash rate becomes a little clearer.

In discussing its forecasts, the RBA’s quarterly statement said:

“In preparing the domestic forecasts, a number of technical assumptions have been employed. The forecasts are conditioned on the assumption that the cash rate moves broadly in line with market pricing as at the time of writing. This assumption does not represent a commitment by the Reserve Bank Board to any particular path for policy.The exchange rate is assumed to remain at its current level over the forecast period (trade-weighted index (TWI) at 62.5 and A$ at US$0.75).”

If we assume this was written somewhere between the RBA’s May board meeting and the release of the Statement on Monetary Policy, the market had a better than even chance of the RBA cutting rates again.

This means the RBA is forecasting the rate of inflation to be either below or at the bottom end of their target range over the forecast period, even with a lower cash rate than at the time of writing.

Adding to the weight of risks suggesting the RBA will cut again was the most recent jobs data in the US. The link between our monetary policy and the US has been well documented, and any delay in rate hikes in the US will have an impact on our own monetary policy.

The data confirms a loss of momentum in the US economy so far over the course of 2016. This has seen the market pricing for the next rate hike from the FOMC push out to next year, while economists have also been revising their expectations.

With inflation to remain weak – even with the assumption of a lower cash rate – and the FOMC likely to take even longer than previously thought before announcing their next hike, I expect the RBA will need to cut the cash rate again. The RBA may wait to see the next inflation print in July, making August the most likely date; however, given the extent of the inflation downgrade in the SoMP, the risk is that they go earlier.

Australian Economic Highlights

  • Growth managed to beat expectations in Q4 with GDP rising by 0.6%, down from 1.1% in Q3 with the annual rate firming from a revised 2.7% to 3.0%. Household consumption was 0.8% higher over the quarter, accounting for two thirds of total growth as the services sector continues to do the heavy lifting for the economy.
  • CPI posted an unexpected fall of 0.2% in Q1 against expectations of a 0.2% rise. The fall saw the annual rate slip to 1.3%. The core rate was weak, rising by 0.15%, well short of the 0.5% that was expected. As a result, the annual rate of core inflation fell below the RBA’s target band to 1.55%.
  • After a net decline over the past three month the employment data was firmer in March with total employment growing up by 26,100 jobs with a big swing towards part-time employment. Despite the softer growth recently unemployment continues to drift below 6.0%, easing to 5.7% in March.
  • ANZ job ads remained volatile once again in April with a decline of 0.8% more than offsetting the revised 0.1% rise from the previous month.
  • NAB business conditions index eased back in April but remains relatively firm with profitability and trading conditions still holding up. Business confidence also eased back in April with the index slipping from 6 to 5 and still remains above the long run average.
  • Consumer confidence continues to struggle with another fall in April with the 4% decline taking the index well below the key 100 level. The fall in April was broad based with family finances, both compared to a year ago and the year ahead, falling 3.9% and 6.6% respectively. Economic expectations over the short and medium term were also substantially lower,  5.5% and 6.0% respectively.
  • Retail sales managed a small improvement in March after stalling the previous three months. Total sales were up by 0.4%, a little more than expected, thanks to a sizeable increase in food spending. Spending on discretionary items remains very inconsistent from month to month.
  • Housing finance improved somewhat in February after heavy declines in the first month of the year. The number of owner-occupier loans was up 1.5% with the value of occupier loans rising 1.7%. Interestingly, investor lending posted a substantial increase of 4.1% which would have caught the eye of the regulators.
  • Growth in outstanding credit according to the RBA’s credit aggregates eased back in March to 0.4%. Housing lending continued to be the biggest driver along with business lending while personal lending continues to fall.
  • Australia’s trade deficit finally showed signs of improving in March. The deficit printed at $2.2bn which was much better than the previous months $3.4bn and better than the $2.9bn expected. A rise in exports was the main driver behind the improved deficit with the rebound in commodity prices helping.
  • Building approvals bucked its trend, posting a second consecutive gain in March. Total approvals were up by 3.7% for the month which saw the annual decline trimmed to 6.5%.
  • The growth in motor vehicle sales recovered in March to post a gain of 2.2% taking the annual increase to 4.2%. Surprisingly the sale of SUV’s were down for the second straight month with the decline offset by an increase in other vehicle sales, while passenger vehicle sales remained steady.
David Flanagan

David Flanagan

Director: Interest Rate Markets