RBA on hold, with a keen eye on the Fed: HSBC's Paul Bloxham
GUEST OBSERVER
Having cut its cash rate by 25bp last month, in response to the very low Q1 CPI print, we see the RBA on hold this month.
Although inflation is below the 2-3 percent target, strong local growth is expected to gradually lift inflation back to target over time
Our central case is for a further 25bp cut in August; however, the RBA will have a keen eye on the Fed, as a further large fall in the AUD could obviate the need for another cut
The Fed and the AUD
The key local development over the past month has been the upside surprise to Q1 GDP, which grew by a stronger-than-expected 3.1 percent y-o-y. However, most of the surprise was to exports, with growth in domestic demand remaining only modest and local income growth quite weak.
In short, although the RBA could consider revising up its growth forecasts as a result of the Q1 GDP print, the composition of the growth means that the outlook for low inflation is likely to remain unchanged.
However, we do think that the stronger GDP combined with the signs of continued modest improvement in the labour market are likely to keep the RBA from considering a cut in June or July. Indeed, given that the driving factor for the 3 May 25bp cut was the surprisingly weak Q1 CPI print, and that the meeting’s minutes revealed that the RBA board was hesitant about that cut, we think the RBA will need to see the Q2 CPI before it would consider a further cut.
Our central case is for the RBA to cut its cash rate by a further 25bp to 1.50 percent in August, following the Q2 CPI print (we expect the trimmed mean to be around 0.4-0.5% q-o-q), and for the central bank to hold steady at 1.50% over subsequent quarters.
However, as always, there are risks to this forecast. A key factor in play at the moment is the Federal Reserve. An improving US economy and more hawkish commentary from Fed officials mean that the market is now pricing in a 55 percent likelihood of a Fed hike by July (HSBC’s economists expect a 25bp Fed hike in September).
A key result of the more hawkish Fed has been a depreciation of the AUD, which has fallen from USD0.78 in mid-April to around USD0.72 recently. At same time, commodity prices have held up, particularly supported by higher iron ore prices.
If the Fed does lift its policy rate in coming months and this pushed the AUD lower, it could discourage the RBA from cutting. In addition, local housing prices are, once again, rising, which could make the RBA more reluctant to cut further. We see the RBA on hold in June and July, and have a cut pencilled in for August, after the Q2 CPI. However, the risk to this view is that the RBA delivers less, not more, in our view.
The June meeting is likely to be uneventful
The key development since the RBA’s last meeting has been the upside surprise to the Q1 GDP numbers. GDP rose by a stronger-than-expected 1.1 percent in the first quarter and was 3.1 percent higher y-o-y (Chart 1). However, the upside surprise mainly came from exports, while domestic demand and local income growth remained too weak to lift inflation. The consumption deflator – which is the measure of consumer price inflation in the GDP numbers – was particularly weak, falling -0.1 percent q-o-q and up only 1.2 percent y-o-y. This helps to explain why underlying inflation fell to a more than two-decade low in the first quarter, despite the strong GDP growth.
The range of other domestic indicators has generally shown solid growth. Building approvals were stronger than expected, prolonging the housing construction boom, and the retail numbers for April were solid (3.6 percent y-o-y). Jobs growth was as expected in April (2.1 percent y-o-y) and the unemployment rate was steady at 5.7 percent. Our labour market index, which aggregates a collection of timely jobs market indicators, suggests continued modest improvement in labour market conditions (Chart 2).
In sum, although inflation is too low, and the case could be made for a further cut, an immediate cut seems unlikely. Keep in mind that the RBA has a ‘flexible’ inflation-targeting regime, which allows the CPI to be outside the band for periods of time, without requiring an immediate response. The RBA’s own forecasts have underlying inflation remaining below the bottom edge of the target band until mid-2018 (Chart 3). The key question the RBA will now be asking, month-to-month, is whether developments over the past month make it more or less likely that inflation heads back to target over that time horizon.
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What the Fed could mean for the RBA
A key development that could affect the local inflation outlook and the RBA’s willingness to cut further is the recent shift in policy rate expectations of the Federal Reserve. The main channel through which this impacts the RBA is the effect it could have on the AUD.
The AUD has already fallen from a peak of USD0.78 in mid-April to around USD0.72 recently (Chart 4). At same time, commodity prices have held up, particularly supported by higher iron ore prices, which has driven the commodity price index to an seven-month high in AUD terms. The fall in the AUD should help to support growth, particularly as growth is being more driven by services exports, which are exchange-rate sensitive. The lower AUD should also help to lift inflation.
Watching what the Federal Reserve does in coming months has a bearing on the RBA’s outlook largely through its likely effect on the AUD.
