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Will the RBA cut rates again? These are possible triggers

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By David Bassanese 

Following the Reserve Bank of Australia’s historic decision to cut the official cash rate to a low of 1.5% last week, analysts are again naturally divided over the question of whether more rate cuts could be in the pipeline.

In answering this question, it helps to know exactly why the RBA cut rates last time, and exactly what the Bank will be watching in the months ahead.  

Let’s be clear: the key reason the RBA cut rates last week was set in motion in late April when the March quarter consumer price index report revealed annual (i.e. year-on-year) underlying inflation had dropped from around 2% to 1.5%.

The RBA did not just react to that number when cutting rates in May: more important was the associated move by the RBA to re-consider its forecasts for how quickly inflation would likely rise over the coming year or so.   

As revealed in the May Statement on Monetary Policy, the RBA gave up believing underlying inflation would pick up anytime soon, due to both more intense competitive forces in the economy (thank you Aldi) and a much more flexible than anticipated labour market.

As seen in the chart below, stronger retail sector competition means the pass through of higher import costs - due to the weaker Aussie dollar in recent years - is much less than we’ve previously seen.

 

At the same time, growth in wages and unit labour costs remains very low – which is due to both a soft and flexible labour market, but also because of a need to unwind the relatively strong pace of wage growth (by global standards) that we enjoyed during the mining boom, which effectively helped push up our real exchange rate.

 

Of course, the initial reaction of many economists following the June quarter inflation results – which revealed annual underlying inflation had held at 1.5%, and so in line with the RBA’s downwardly revised May forecasts – was to think the RBA would not be inclined to cut again.

But this was a wrong assessment: as I argued, the RBA still saw reason to cut last week because the June quarter CPI result had confirmed its expectation that inflation was on a lower trajectory than it had previously thought.

Given this background, whether or not the RBA cuts rates again in coming months will critically depend on whether the Bank retains confidence in its forecast that annual underlying inflation will rise over the coming year from around 1.5% in the June quarter of this year, to 2% by the June quarter 2017.

That, in turn, could depend on many factors, but most particularly whether there’s some lift in the still relatively low pace of wage inflation across the economy. My hunch is that wage growth won’t rise fast enough, and the RBA will be eventually forced to revised down its June 2017 annual underlying inflation forecast to sub-2%.  

If so, and following its recent playbook, the RBA will likely feel the need to cut interest rates again. One scenario under which this could happen is if annual underlying inflation dropped below 1.5% - to say 1.25% or even 1% - by either the September quarter or December quarter CPI inflation reports over the coming six months. If it happens by the September quarter report due in late October, we could be set up for another rate cut on Melbourne Cup day in November. 

Note, moreover, all this is assuming that the economy still travels along fairly well – at a pace strong enough to at least keep the unemployment rate relatively stable at around 5.75%. That’s because, as I’ve argued here previously, the RBA feels one of the reasons inflation is proving stubbornly low is the lingering degree of spare labour market capacity in the economy.  

At just under 6%, the unemployment rate is not bad – but it could be comfortably lower, particularly given it likely also understates the degree of labour market slack due to a still elevated level of Australians either working few hours than they would like, or simply discouraged from looking for work at all. 

With low inflation, the economy can afford to grow at an above-trend pace – or, as the RBA put it in its August Statement on Monetary Policy last Friday, “while the prospects for growth in economic activity are positive, there is room for even stronger growth.”

The other situation in which the Bank would likely cut rates is if the economy weakens back to a clearly below-trend pace, such that the unemployment rate firmly pushes back above 6%. That’s possible – though I increasingly feel unlikely anytime soon - if consumer suddenly stopped spending and/or the housing construction boom took a sudden turn for the worse.

I’d also throw in another rate cut scenario: a move by the $A back toward US80c, possibly because of further global monetary stimulus, or delayed rate hikes in the United States. Under this scenario, the RBA would likely feel little alternative than continue in the “global currency wars” to stop a rising $A undermining the improvement in business competitiveness and confidence over the past year.

All up, the good news is that the RBA has got the economy’s back. For a variety of reasons, inflation is proving to be stubbornly low, which means we have capacity to lift our sights and aim for an even stronger pace of economic growth.   

Published: Wednesday, August 10, 2016


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