Bill Evans: RBA to cut next week

Fresh from Westpac’s Bill Evans:

The Reserve Bank Board meets next week on February 3. Since we changed our view on December 4 last year we have consistently argued that the board will decide to cut the cash rate by 25bps at this February meeting. In the discussion below we set out the reasons why we have retained that view.

In last week’s note we highlighted the relevance of the December quarter inflation report as an important input to the policy decision. The report showed a slightly higher quarterly print on both headline and underlying inflation.

We expected 0.1% on the headline and 0.6% on the underlying measure (the average of the two core inflation measures, the ‘trimmed mean’ and ‘weighted median’). In the event they printed 0.2% and 0.66% respectively. That is not enough of a difference to change our view around the likely downward revisions to the inflation outlook which the Bank will release on February 6 in its quarterly Statement on Monetary Policy (SoMP).

As we anticipated, annual headline inflation still eased back sharply from 2.3% in September to 1.7% in December. Similarly annual underlying inflation eased back from 2.5% in September to 2.2% in December.

This means that the Bank is likely to significantly revise down its inflation forecasts.

Recall that the Bank’s last set of forecasts in November were based around a crude oil price of US$86/bbl (Brent) compared to the current price of US$49/bbl. That fall in the oil price has markedly affected the print for the December quarter CPI and expectations for the March quarter CPI.

In November the Bank forecast underlying inflation for the year to June 2015 at 2.5% and 2.75% for the year to December 2015. We expect those forecasts will now be cut to 2.25% and 2.25% respectively. The lower core measures will incorporate a markedly weaker growth outlook (see below) which will further increase Australia’s negative output gap – recall that Australia’s growth has been below trend for six of the past seven years and that 2015 is expected to be another below trend year for growth, putting further downward pressure on core inflation.

The indirect effect of lower fuel prices on components such as holiday travel, and on the cost bases of companies, particularly with respect to transport costs, will also impact the RBA’s core inflation forecasts. Most importantly it should be reasonable for the Bank to assume a lowering of inflationary expectations which will also impact on its core inflation forecasts.

This expected lowering in the RBA’s core inflation forecasts for 2015 means that the Bank would be changing its inflation narrative from expecting a move to the top half of the target band to prospects of remaining in the bottom half of the band – a significant turnaround.

We also expect the Bank to lower its growth forecasts in the February SoMP. The Bank is likely to adjust its forecasts for the soft spot in activity that it did not anticipate in its November forecasts, and to include the ongoing drag from the terms of trade on nominal incomes. These negatives will dominate any positive effects from lower fuel prices and a lower AUD.

It is reasonable to assume that having moved through that negative shock the economy will take more time to build momentum. That would see the soft momentum we saw in the September quarter extend through the December quarter and into the March quarter of 2015 with the expected lift nearer the end of the year taking longer to come through.

This expected delay is likely to see growth rates revised down from 2.5% (2014); 3% (2015); and 3.5% (2016) – which were the November forecasts – to 2.25% (2014); 2.5% (2015) and 3% (2016) in the February SoMP. That is, a 0.5% cut across the entire forecast period. This would be a material change and, accordingly, as with the lower inflation forecasts, justifies, indeed demands, a policy response.

Last week I noted that a feasible barrier to cutting rates was the low probability given to such a move by the market. The RBA does not have a history of surprising markets. Market pricing at the time gave only a 25% probability to the cut. That has now lifted to a ‘respectable’ 65%; indeed, arguably a level that would pressure the Bank to explain itself if it chose not to move.

That ‘surprise aversion’ argument may not be as strong a reason as in the past We have seen a stream of central banks surprise markets with dovish policy moves: India; Canada; Denmark; and Singapore. Even the doggedly hawkish Reserve Bank of New Zealand raised the possibility of cutting rates in its latest Statement.

Finally we have the signal from the yield curve. Figure:1 shows that the past four easing cycles have all been coincided with the 10 year bond rate moving close to the overnight cash rate. Long bond rates around the cash rate indicate that policy is unnecessarily tight.

Central banks could argue that in the era of QE the bond rate is not sending reliable signals about the outlook for growth and inflation although that would be a risky approach given the time honoured reliability of the yield curve shapes in that regard.

In conclusion, we remain comfortable with our view that the Bank will cut rates by 25bps next week.

Houses and Holes
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  1. Well that was entirely predictable.

    A bank economist notes that while inflation is under control the Central Bank has no excuse not to further goose the demand for top quality debt merchant product with even juicier bait rates.

    Of course no mention of the fact that the reason the economy outside mining has been verging on a coma for the last few years is that the household sector are gagging on the IOUs they sold the debt merchants over the last 17 years.

    Nope, no mention of that at all.

    The only cure for that affliction according to a Bank economist is for the Central Bank to try to lower the price of debt even further (until the CAD blocks that strategy) and attract the debt junkies who never say never.

    • Well if they do cut in the current world market it will tank the dollar and undermine foreign real estate investment creating capital flight and crashing the market.

      I’m all for it !!

      • Yep.

        It will be interesting to watch the RBA try to reduce the dwindling carry trade differential just as the international love affair with Oz and commodities is coming to a close.

        The supply of CCP duffle bags full of cash seems to be drying up as well.

        Perhaps Mr Robb’s boot sale of Aussie assets will earn us some chump change.

        A nice low dollar should fill our beaches with tourists looking for a back rub and a jug of home brew.

        No worries.

  2. mine-otour in a china shop

    With the economy firing on the single engine of the FIRE sector, we need more power. They have already got APRA and the RBA wrapped round their little fingers.

    Wonder how Bill and the shareholders would react to a compulsory 10% deposit on lending for housing up to the equivalent of $310k and 20% thereafter, or 20% straight up deposit for investors (like the Irish model)?

    But Australia isn’t Ireland.. its Grong Grong.

  3. Easing cycle starting with OCR at 2.5%.
    ZIRP here we come . Alarmingly we also have austerity at all levels of government just to make sure that ZIRP is still to high.
    Callum over at BS has a great chart today showing credit growth clearly topping out especially business credit.
    This is the year of recession for Australia . Abbot will push the Austerity even harder ensuring his and the LNPs certain demise .

  4. I understand basel3 will be implemented around mid year. Anyone able to give some interpretation what this may mean for the banks?

    I don’t see it slowing lending what so ever but id like to hear what others think?

    Basel3 + declining tot + declining gdp per capita + commodities collapse + fast decline aud and locals business slow to jump onboard + labor to win next election + hitting new personal debt to gdp highs = housing boom

    • Cba hit $90 with a p/e of 17…. Hmm anyone at all factoring risk? Anyone at all factoring in just how much goverment holds these banks up?

    • Haven’t read much about Basel III since they postponed it a couple of years ago.

      Do remember that if they buy gold for reserves, it now counts at full 100% whereas before Basel III they could only use 50% its actual value.

  5. Bil Evans – who predicted USD parity by year end last Sept – who predicted continued strength in commodity prices off the back of the urbanisation of another $1billion chinese – who I stupidly listened to and held off on a short that would have made a motza!!

    • In my book, ANY economist who could not give at the very least 12 months warning before the GFC isn’t worth a crumpet…not even a sausage…
      James Turk got it right about 4 years before…plenty of others did too.

    • He also predicted the Aussie dollar would be at 96c at Jun last year, and the cash rate would be at 2%!
      Must have been predicting Armageddon in the US.
      Not his finest moment.

  6. One more thing… Large proportion of our big banks are held by american banks.

    Could we be witnessing a pump and dump? Just think about it. If you are a american bank holding a 20% stake in cba or nab. Do I need to say more?

    They will dump these shares surely.

  7. Still awaiting an explanation of how a rate cut will help…at least for those other than property investors.

    AUD down, oil down, nice for exporters (which should already have preferential tax rates) poor for importers…what’s the rush. Sit is out for another month. Or three. And jawbone.

    • Fear dude, I think its all fear at the moment. In Europe and Asia etc. …and part of me wonders if there is fear here (in the elite circles at least) that we dont fear enough and arent quite on to what is happening elsewhere.

      That rate cut (I think the China and German data points to them needing to do something, the Swiss the Kiwis the Canadians and Indians etc) for mine is about preventing the meltdown that could have been avoided if they had used the mining boom a tad more intelligently, and if the private debt side of the ledger was not as profoundly ugly as it is. But we fried the external side, and hollowed out the import competing side, and its always been a never better time to buy the worlds most expensive real estate. So that adjustment is going to be a classic. And its here.

      • I don’t think that actually answers the question “how a rate cut will help”?

        Exactly how will it “prevent the meltdown?

        There never really is a valid explanation of that.