RBA reacts strongly to March inflation report: Westpac's Bill Evans

RBA reacts strongly to March inflation report: Westpac's Bill Evans
RBA reacts strongly to March inflation report: Westpac's Bill Evans

GUEST OBSERVER

In a decision that surprised Westpac the Reserve Bank Board decided to lower the cash rate by 25bps to 1.75 percent.

However it has not retained its easing bias choosing to end the Governor’s statement with: “Taking all these considerations into account, the Board judged that prospects for sustainable growth in the economy, with inflation returning to target over time, would be improved by easing monetary policy at this meeting”.

We do not consider that to be particularly significant. After most decisions to move the rate the Board does revert back to a neutral stance. For example we saw that in February last year but that did not preclude a further cut in May. Indeed it is our view that this decision is so significant that it would not be taken without a realistic expectation that a further cut is likely.

We expect that cut will be delivered in August following the release of the June quarter inflation report. Inflation has become the most important policy driver as a result of this decision and we do not expect that the June quarter report will provide the Bank with sufficient comfort around the inflation outlook.

The best guide on this inflation approach will be provided in the forecasts in the next Statement on Monetary Policy to be released at 11.30am on May 6. In our preview to this decision we expected that the staff would advise the Board that on a ‘no policy change’ basis underlying inflation would remain below the 2–3 percent range in 2016 but drift back to around 2¼ percent in 2017.

The forecasts on Friday will entail “market pricing” which envisages a second rate cut by early next year. With two rate cuts relative to  the Bank is likely to indicate a return to the bottom of the 2-3 percent range but is also likely to put a fairly wide confidence interval around that forecast. By relying upon another rate cut to achieve the target we think it is reasonable to expect that the second rate cut will be delivered by August.

The significance of the inflation report in shaping this decision is really highlighted by the Governor’s decision to include “This follows information showing inflationary pressures are lower than expected” in the introductory paragraph. Our check of statements associated with rate moves shows that the last time a reason was highlighted in this way was May 2012, citing weak growth and inflation, and you have to go all the way back to November 2006 to see another example where upward inflation pressures were emphasised.

Further, in the Governor’s statement the recent data is described as “unexpectedly low” along with “very subdued growth in labour costs and very low cost pressures elsewhere in the world”. Given this high degree of sensitivity to the recent change in the inflation environment it is hard to believe that the Bank would not take the opportunity to cut rates further following the next inflation report.

There were some other surprising qualifications around the state of demand in the economy. We thought that the Bank was encouraged by the recent fall in the unemployment rate to 5.7 percent but the statement says: “Labour market indicators have been more mixed of late”.

We also thought that the Bank had been encouraged by the 3% growth print for 2015 but growth in 2016 is now being described as: “continuing … though probably at a more moderate pace”.

Our read of the Banks’ assessment of the household balance sheet suggested that it was concerned about the ongoing high level of household debt but the statement explicitly notes that risks of lower interest rates in the housing market have lessened.

Finally, despite the fact that the trade weighted index has actually fallen modestly since the April Board meeting, concerns around the appreciating exchange rate were once again raised. We believe that the Bank had been expecting the US Federal Reserve to resume raising rates in June. However now with the US data, outside the labour market, slowing and markets giving virtually no chance to a June move the Board is probably now formulating its decisions around a delayed rate hike from the US Federal Reserve. Without interest rate relief in Australia this environment could reasonably be expected to exacerbate concerns around the exchange rate.

We have also revised our own view that the FED will delay its decision to resume raising rates until September from the current forecast of June. While a respectable case remains for June there does not appear to be sufficient urgency from the Federal Reserve to move by June.  From there we expect that the FED will resume its six month timetable with the next move timed for March rather than December.

On the global front the Governor notes that growth forecasts have recently been revised down further and he specifically notes that recent data in China has improved but attributes that to recent actions by policymakers and emphasises that this action may only support the “near term outlook”. We certainly agree with that assessment given the emergence of a substantial property bubble in the ‘Tier 1’ cities.

Conclusion

We have been surprised by the strength of the response of the Bank to the March quarter inflation report. Having once again reverted to lower rates despite much questioning of the effectiveness of monetary policy the Governor has revealed an inclination to continue to use monetary policy in pursuit of his inflation target. With the risks around weak wages growth, global disinflation and potentially slowing demand it seems highly likely that he will choose to cut rates further with the next move timed for August.

That is likely to be the last policy move from this Governor who is scheduled to retire in September.

Bill Evans is chief economist of Westpac.

Michael Crawford

Michael Crawford

Michael is the real estate reporter for western Sydney and loves writing about homes and the people who live in them. A former production editor and news journalist, he enjoys writing about real-world property purchases as well as aspirational buys and builds. Following a recent move from Sydney’s northern beaches, Michael now actually enjoys commuting.

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