RBA view change: low CPI to see a 25bps cut in May

Today’s CPI produced the lowest quarterly and annual rates of core inflation recorded since the RBA commenced inflation targeting – and rates that are starting to diverge below the lower end of the Bank’s target band.

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  • NAB now expects the RBA Board to endorse a 25bps rate cut at its May Board meeting
  • We assess this as a 55%/45% chance reflecting the Bank’s ability to do slightly more to reduce Australia’s unemployment rate given the very low inflation situation in Australia revealed by today’s very low core CPI outcome.
  • That said we remain generally optimistic about the near-term performance of the Australian economy and labour market, especially on the east coast of Australia. It is really a fine judgment about the lack of risk in adding a touch of stimulus given low inflation.

Today’s CPI produced the lowest quarterly and annual rates of core inflation recorded since the RBA commenced inflation targeting – and rates that are starting to diverge below the lower end of the Bank’s target band (albeit that band is expressed as an average over the course of the cycle). There is a wide range of factors driving these low inflation outcomes. Some are clearly cyclical, like lower energy prices, and seem more permanent, like the very low level of wage growth despite a falling unemployment rate. Few of the factors behind low inflation represent a particular signal of demand weakness in the Australian economy – especially the non-mining economy.

The RBA will assess today’s inflation result, and other factors, in the days ahead as they make their new forecast to be delivered to the RBA Board next Tuesday and the public in next Friday’s Statement on Monetary Policy. The February forecasts showed medium-term inflation consistent with the midpoint of the RBA’s band. It will be surprising if this new forecast isn’t lower than their February forecast – certainly for 2016 and possibly beyond. Australia’s RBA remains an inflation-targeting central bank, so faced with this new lower inflation forecast it now seems likely that the Bank’s Board will vote in May to take the opportunity to provide some slight further assistance to the Australian economy and so potentially help lower the unemployment rate more quickly than previously forecast.

To be sure, whether to cut rates or not will likely be a close call. The activity data do not argue for the need to cut rates now or that the unemployment rate will not continue to gradually decline in the near term. That said, as NAB starts to extend its economic forecasts towards 2018, the outlook suggests less upward pressure on interest rates as the housing cycle wanes, the boost from LNG exports eases and the positive effects from the lower $A subside. As a consequence we are also reviewing our forecasts for cash rate increases previously predicted in 2017.

In making this forecast change, we also considered the arguments against making such a move. These included:

  • Unemployment is currently falling – it is rare for the RBA to cut rates when the unemployment rate is falling;
  • The recent activity data suggest the economy maintains momentum and the labour market continues to improve, especially along the east coast;
  • The predominant sources of low inflation do not signal weak demand in Australia; and
  • Reducing interest rates may reignite demand in the housing sector.

In this regard the decision could well come down to a value judgement by the RBA’s Board. What are the risks of a small further easing, given very low inflation? Would a slightly lower interest rate help keep the $A lower and taken together help assist demand in the economy and perhaps lower unemployment more quickly? In a close call, NAB now expects the Board to vote to reduce the cash rate by 25bps at the May Board meeting.

At this stage we think that a further rate adjustment may be a close run thing. While we have not formally included another cut much will depend on non- mining activity, the currency and unemployment. Also relevant will be confirmation of continuing low inflation in coming quarters.

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