From Bill Evans at Westpac:
The Reserve Bank Board meets next Tuesday to decide whether to cut rates. Markets and media are strongly favouring a rate cut.
We are sticking with our view that the Board will decide to hold rates steady.
Until the release of the March quarter Inflation Report speculation of a rate cut was limited to only a few commentators and markets rated the probability of a cut at around 10%.
The March quarter Inflation Report printed underlying inflation at 0.2% compared to market expectations of 0.5%. Annual core inflation fell to 1.5%, from 1.9%, which is well outside the Bank’s target zone of 2-3%.
The question is whether this surprise result will trigger the Board to activate its current easing bias and cut the cash rate by 0.25% next Tuesday.
In deciding whether the Board will take this action we need to cast the decision in the framework that we expect the Board will follow.
That framework will be around whether the Board is informed that if policy is not changed then the Bank is likely to miss its inflation and growth targets.
Missing the target is not about moving outside the target range in the near term but staying outside the target range in the medium term.
In that regard we do not believe that the Bank’s growth forecasts, which were last reported in February, will change.
The Bank currently expects GDP growth in 2016 and 2017 at 3.0% and annual growth through to June 2018 at 3.5% (range of 3-4%). That forecast is for growth slightly above trend which we assess at 2.75%. Growth relative to trend is important for central banks since above trend growth is consistent with a steadily falling unemployment rate. We saw that in 2015 where growth of 3.0% was consistent with a fall in the unemployment rate to 5.8% from around 6.2%.
Since February the most important developments on the “growth scene” have been the rise in the AUD and commodity prices. With a higher AUD and 40% of Australia’s exports being in services and manufactures along with the higher commodity prices the Bank can be expected to have raised its terms of trade forecast while the higher AUD can be expected to impact exports from a competitive perspective. On net I expect the Bank will retain its February growth forecasts of above trend growth in both 2016 and 2017.
There will be changes to the Inflation forecasts. Our interest is the “no policy change” inflation forecasts which will be presented to the Board.
Recall that current underlying Inflation forecasts for 2016 and 2017 are 2.5%.
With 0.2% printing for the first quarter of 2016 our forecast for underlying inflation for 2016 is around 1.8% – partly reflecting the indirect effect of a rise in the petrol price; seasonality in education and health; no further slowdown in housing pressures and some impact from a progressive tightening in labour markets. This view is also predicated on some lagged pass through to core inflation from the fall in the AUD over the last few years (recall that, in February, the RBA expected the pass through to add 0.5% in both 2016 and 2017). It is likely that the Bank will maintain its expectation of a pass through although it will probably lower the pass through effect given the evidence around clothing; holidays; and appliances in the March quarter report. However this evidence for just one quarter is unlikely to see the Bank completely abandon any pass through effect.
We expect that the Bank will also adopt a 1.75% forecast for core inflation in 2016 – sharply down from the current 2.5%. That will be a big admission for the Bank – substantially larger than our own given we were forecasting 2.1%.
The “no policy change” forecast for 2017 will be much more important. If, for instance, the “no policy change” forecast was also marked down to 1.75% then there would be little choice but to cut rates on Tuesday. The RBA has consistently argued that inflation can drift outside the target zone in the near term as long as there is some comfort that it will move back within the zone in the medium term. Two years outside the zone would be unacceptable and would require a policy response. Consider for example the post GFC period when inflation was consistently above the top of the band but the forecasts based on slowing growth anticipated inflation moving back inside the band.
Our own core inflation forecast for 2017 is 2.0%, down from 2.2% before the March quarter Report. We expect the Bank is likely to favour 2.25% in 2017 – down from 2.5% in February. That will be predicated on some ongoing pass through from the AUD; and a more prominent role being played by “output gap” analysis in the second year forecast as “bottom up” forecasts become less reliable.
It is crucial that the Bank maintains its GDP growth forecast of 3.0% in 2017 – above trend of 2.75% and indicating some upward pressure on inflation from a tightening of the output gap including a strengthening labour market.
Similarly it is likely to maintain its 2.5% forecast for underlying inflation out to June 2018 with the output gap playing the dominant role in the forecasting process. Recall that the RBA is currently forecasting annual GDP growth to June 2018 of 3.5%.
Confronted with a “no policy change” forecast for inflation to move back within the band and above trend growth the Board is likely to hold rates steady.
If however, the Board is advised that “no policy change” will see underlying inflation stay outside the target zone in both 2016 AND 2017 then the Board will cut rates. 28 April 2016 2 Bulletin Past performance is not a reliable indicator of future performance. The forecasts given above are predictive in character. Whilst every effort has been taken to ensure that the assumptions on which the forecasts are based are reasonable, the forecasts may be affected by incorrect assumptions or by known or unknown risks and uncertainties. The results ultimately achieved may differ substantially from these forecasts.
From Westpac’s perspective a decision to cut will be accompanied with clear guidance of a further move.
A cut will certainly be followed by markets’ pricing in a second cut and the RBA franking that second cut by assuming “market pricing” for its revised forecasts which will undoubtedly include underlying inflation returning to the target zone in 2017, although it is unlikely that, even with 2 more cuts, underlying inflation can be expected to return to the target zone in 2016.
It is reasonable to ask why the Board would not see little risk in cutting even if it was being advised that inflation was expected to move back into the zone without a move.
We believe the Bank is also concerned about Australia’s lack of progress in lowering household debt. Our household debt to disposable income ratio remains “world class” and lower rates would be of little help in boosting business investment whereas household debt is likely to be the sector of the economy responding to the rate cut.
We also expect that the RBA believes, as we do, the guidance from the US FED that it can be expected to raise rates on two occasions in 2016 and 2017. That will substantially tighten the AUD/USD rate spread and ease pressure on the AUD without risking a further “blow out” in household debt.
The Bank is also likely to be quite sceptical about the sustainability of the recent upswing in the China data and could anticipate additional downward pressure on the AUD.
However we do not believe that the timing of the Federal Budget; the upcoming Federal election; or the imminent retirement of the Governor will affect this decision.
The Governor has shown himself to be indifferent to political events while I have no doubt that, being the professional he is, he will remain in total control until the day he retires.
Hmm, well, the bank’s growth forecasts are awfully high and it will have its hand forced at some point. If it is worried about household debt then that is roughly four (twenty) years too late. Not that it shouldn’t be but it just blew the bubble for Heaven’s sake. And, that it can’t get on the phone to APRA and co-ordinate rate cuts with further macroprudential tightening is negligent.
Other than that, it’s all good at Martin Place.
