From Bill Evans at Westpac:
The minutes of the July monetary policy meeting of the Reserve Bank Board confirmed the importance of next week’s June Quarter inflation report.
The key sentences in the concluding paragraph of the “Considerations for Monetary Policy” section state: “The Board noted that further information on inflationary pressures, the labour market and housing market activity would be available over the following month and that the staff would provide an update of their forecasts ahead of the August Statement on Monetary Policy. This information would allow the Board to refine its assessment of the outlook for growth and inflation and to make any adjustment to the stance of policy that may be appropriate.”
So the minutes clearly leave the door open for another rate cut in August.
But this will depend upon the June quarter inflation report’s estimate of underlying inflation. The upper bound below which a rate cut can be expected is likely to be 0.5%.
Westpac’s forecast for underlying inflation in the quarter is 0.35% (up slightly on our preliminary estimate of 0.30%) which would support the need for another move given that core inflation would only have risen by 0.55% over the course of the first half of 2016, raising a genuine question mark as to whether even the Bank’s current 1.5%yr mid-point forecast for December 2016 could be achieved. A lower result for 2016 would also place their 2.0% forecast for 2017 (the bottom of the 2-3% target range) in jeopardy.
What are the risks to our forecast and what is the level of June quarter inflation above which the Bank would keep rates on hold?
The tone of the minutes indicates that the Bank may be leaning toward another rate cut and may have a bit more flexibility on the inflation result than we had expected.
It is useful to note the Bank’s own expectation for the print.
In the Statement on Monetary Policy in May, it forecast underlying inflation would print 1.5% for the year to June. With nearly 1.0% already being reached in the first 3 quarters, we can conclude that the Bank is expecting a 0.5% print for underlying inflation in the June quarter. That result would therefore be interpreted by the Bank as being in line with its overall inflation outlook, which is for underlying inflation to print 1.5% for calendar 2016 and 2.0% for calendar 2017.
The result would provide support for its forecast changes in May and indicate that it had not overreacted to the very low print of the March quarter.
Recall that the May forecasts assumed “market pricing” on interest rates, which incorporated a fully priced second rate cut by early 2017.
I think it is therefore reasonable to conclude that a 0.5% print for underlying inflation, although representing a sharp jump from March’s 0.2% print would be consistent with a follow up rate cut at the August meeting.
Another way to look at it is that 0.5% would still represent an annualised “run rate” of 2.0% which is still at the bottom of the 2-3% target band.
In the May Statement on Monetary Policy, the Bank noted “Although some temporary factors contributed to the low result, the data indicate that there has been broad based weakness in domestic cost pressures, reflecting low wage growth, heightened retail competition, softer conditions in rental and housing construction markets and declines in the cost of industry inputs such as fuel and utilities.”
Theoretically the pass through from the fall in the AUD should be an offset to these pressures, but there has been only limited evidence of that effect and the fall in the AUD is starting to fade with the currency being broadly stable over the last 12 months – clearly margin squeeze has had a considerable influence on limiting the pass through from AUD depreciation.
Our forecasts for the June quarter expect these trends to be sustained. Lower than expected results across the spectrum of components are consistent, in particular, with low wage pressures and margin squeeze. That stood out in the March quarter result.
Clothing and footwear; processed food; household contents and services and holidays are likely to continue to capture the low wages and retail margin squeeze effects in the June quarter. We have made allowance for those factors in our forecasts.
However, by far the most important driver of the outcome for underlying inflation is likely to be housing.
Because rent and housing construction costs are not volatile and/or impacted by significant one off factors, they are almost always included in the 70% of items which make up the trimmed mean – the key measure of underlying inflation. With a total of 15.4% in the overall CPI (construction costs, 8.7%; and rents, 6.7%) these two components represent an effective 22% of the trimmed mean – by far the highest weighting of any component.
In recent quarters we have seen a collapse in housing pressures, particularly outside of Sydney and Melbourne.
In the December quarter last year, growth in construction costs slowed from 1.1% the year before to 0.1%; in the March quarter, we saw a continuation of that weakness, printing 0.2% from 0.9% the year before.
The slowdown in rents has been more gradual. The December quarter slowed to 0.2% from 0.5% a year ago and slowed further still in the March quarter to 0.1% from 0.4% a year earlier.
Housing pressures in the June quarter will be critical for underlying inflation. In our preliminary estimates, we assumed 0.1% for rents and 0.2% for housing construction. In our final estimate, we have cautiously lifted these estimates to 0.2% and 0.3% respectively, pushing the underlying measure up to 0.35% – still comfortably in the “rate cut” zone.
If the underlying result printed above 0.5% due to housing, then one combination would be both rents and construction costs printing at 0.6% or above. These results would defy a clear slowing trend in rents, and indicate a possible but unlikely sharp recovery in construction costs and builders’ margins. While entirely possible (e.g. construction costs/ margins lifted from 0.9% to 1.5% between March and June last year), particularly following the lift in house prices (rather than specifically construction costs) in April/May in Sydney and Melbourne, we think the outcome would be unlikely.
Arguably, an unanticipated “spike” in housing costs and rents that offsets the wages/margins forces that have structurally driven down inflation pressures would be an unwelcome outcome for the Bank.
In the event of an upside surprise in the Inflation Report that was largely attributed to a spike in housing costs, the Bank is likely to be more flexible with its ultimate rate decision, but a print above 0.5% would still make it very difficult to justify a cut.
In that event, markets would readily switch their focus to a November cut, expecting some correction to the housing “spike”.
And also from Westpac:
• Westpac is forecasting a 0.5%qtr rise (1.2%yr) in the headline CPI in the June quarter.
• The ABS estimates that June is traditionally a softer quarter with the seasonal factor worth –0.13ppts. This results in the seasonally adjusted CPI rising 0.7%qtr.
• Rising auto fuel prices and a seasonal rise in fresh fruit & vegetables prices are helping to boost the CPI but outside of car prices, the impact of the weaker AUD has been very modest to date.
• Overall, traded prices are forecast to rise 1.1% but this is not enough to prevent the annual pace easing to 0.5%yr from 0.6%yr. Excluding fruit, vegetables, fuel and tobacco, traded goods prices are forecast to rise 0.3% in Q2 highlighting just how modest inflationary pressures are.
• Housing costs remain key to core and non-traded inflation. Housing costs are expected to remain very modest and while we expect a mild acceleration in dwelling and rent costs, utility prices will be flat and other housing cost pressures remain well contained. It is likely that any firming in Perth dwelling prices, following the record 2.2% decline in Q1, are likely to be offset by softer prices in Sydney and/or Brisbane.
• Core inflation (average) is forecast to print 0.3%qtr (0.35% at two decimal places) which will see annual core inflation fall to a new record low of 1.4%yr. The trimmed mean is forecast to rise 0.40% while the weighted median forecast is 0.30%. The six month annualised pace of the average of the core measures is forecast to fall to 1.1%yr from 1.4%yr in Q1 highlighting just how soft the current inflationary pulse is.
• The pass though from the weaker AUD is not providing the normal boost you would expect and so is only modestly offsetting an overall benign domestic inflation environment. Outside of housing, where a statistical bounce is possible, the risks to our forecast are balanced.
My own view is that anything other than a breakout CPI result will see a cut. The non-mining economy is clearly slowing with :
- retail stalling for a number of months. My own liaison is suggesting outright weakness;
- house prices in bubble cities slowing, a lot on some measures and easing credit suggests more ahead;
- no post-election lift to confidence (indeed it has fallen);
- a soft labour market has turned soggy;
- leading indicators suggest more jobs weakness ahead;
- the car industry and residential construction will join mining soon in drawing down capex;
- non-resi investment is also set to roll over in the near future;
- EBA’s suggest further weakness ahead for wages.
Pretty much the only current indicator painting a rosy picture for domestic demand is the NAB business survey and it does not capture enough of the mining sector to be reliable in today’s two speed economy.
The last thing the economy needs now is a higher dollar. They will cut given half a chance, especially since the banks are nearly certain to hold some back.
Problem is, I expect it to do nothing to turn the economy, just like the last cut. The only impact we’re going to get from easing henceforth is through a lower dollar. Which makes you wonder why they don’t just get on with declaring macroprudential the new credit lever and slash the cash rate to 0.5% immediately.
