From Bill Evans, chief economist at Westpac, who believes that the RBA will cut rates by another 0.25% at Tuesday’s meeting and will adopt an easing bias:
The Reserve Bank Board meets next week on March 3. We expect that it will decide to cut to overnight cash rate by 25bps from 2.25% to 2.00%.
On December 4 last year we forecast that the Bank would decide to cut the cash rate by 25bps at both its February and March meetings. At that time market pricing put the probability of consecutive rate cuts at around 15% with the probability of the February rate cut alone (that has since been delivered) at only around 20%.
Even two cuts by May, which is now priced at 100%, was only given a probability of 28% at that time. Throughout the whole of 2014 the Bank had persisted with steady rates and forward guidance of: “the most prudent course is likely to be a period of stability in interest rates.” It was always going to take a considerable change in assessment of the economy to justify such a policy reversal. Cutting only once seemed to be too timid a response.
Arguments that the Bank would wait to assess the impact of the February cut overlook central banks’ assessments that monetary policy acts with a long and variable lag.
It is more likely that the Bank has assessed that the situation has changed sufficiently that at least 50bps of cuts are going to be required. The need to trade off risks of over-stimulating the Sydney property market with the need to contain the rise in the unemployment is likely to have been resolved in favour of the labour market.
Under those circumstances waiting for a month or two would seem to be a sub-optimal strategy.
The Bank justified the February rate cut on the basis that consumption and non–mining investment were taking longer to recover than had previously been expected. This meant that growth was taking longer to return to trend (3-3.25%) than had been anticipated throughout 2014. In turn, a longer period of below trend growth implied that the gradual rise in the unemployment rate would persist for longer and the rate itself would peak at a higher level.
The RBA’s forecasts in its February Statement on Monetary Policy further supported the view that the Bank expects that more than one cut is required to return the economy to trend growth. Those forecasts included the expectation that growth in 2015 would return to 3% under the assumption (market pricing on February 5 when the document was finalised) that the cash rate would fall a further 38bps, including 10bps in March.
Developments since the February rate cut have strengthened the case for a cut in March. On February 12 the employment report printed an increase in the unemployment rate from 6.1% to 6.4%. While that sharp jump should correctly be interpreted as partly monthly volatility, it would have confirmed to the Bank that the unemployment rate had not peaked. Recall that from October to December the rate had fallen from 6.3% to 6.1% potentially creating some doubt around the RBA’s expectation that unemployment would continue to rise.
The quarterly Capex survey, which was released on February 26 and provides the best assessment of likely progress in the rebalancing of the economy away from mining towards non-mining investment, showed a 12.4% fall in investment expectations in 2015/16 compared to the first estimate for 2014/15. Further, the outlook for services investment in 2015/16 points to a 7% fall compared to an 11% lift over 2014/15.
On the other hand, we saw a strong 8% increase in the Westpac-Melbourne Institute Index of Consumer Sentiment driven largely by the February rate cut and the 20% fall in the petrol price since late 2014. Perversely, this positive sentiment response may encourage the Bank to move again given that the Governor has been on record as being concerned that cutting rates might undermine the very confidence they would be aiming to boost.
We also saw the February meeting minutes which revealed that the Board had considered whether to cut in rates in February or wait until its March meeting. Some readers interpreted that as signalling an ‘either/or’ approach that ruled out successive monthly moves. However I think it is better to assess this discussion as the Board feeling uncomfortable with the public perception of a sharp turnaround in stance between December and February. Indicating that March had been considered and explaining that February was preferable timing from the perspective of communication is a simpler and more logical explanation.
And then we have the Australian dollar.
The Governor pointed out in December that he saw the AUD needing to fall to USD 0.75. Our own estimate of fair value puts the AUD at around that level. Prior to the rate cut in February the AUD was trading around USD0.78. Immediately following the cut the AUD traded down to USD0.765 although that level proved to be unsustainable in the near term.
That was probably because the Governor gave no guidance in his statement, leaving the market with the perception of a neutral bias. Since then the AUD recently traded around USD 0.79 and is currently around USD0.785. Markets are currently pricing a rate cut next week with a probability of 50% so no move will probably further boost the AUD.
From my perspective the key to the decision next week will be whether the Governor sees the cash rate as having a natural ‘floor’ of 2%. In that case cutting rates next week with an associated neutral bias might see markets assessing that the Bank has exhausted its rate cutting capacity. Such an assessment would be dangerous from the perspective of holding down the AUD.
My view is that the better approach is for the Governor to assess that he still has ample scope to cut further. Certainly from the perspective of the response of businesses and households to the historically low rates in 2014 and the ‘negative to zero’ policy rates in other countries there is no justification for a 2% ‘floor’.
The policy approach to ensure maximum easing in financial conditions would be to cut rates by 25bps and adopt an explicit easing bias. That bias might not need to be acted on but such a policy would ensure maximum downward pressure on the AUD.
We recognise that anticipating the month to month preferences of the Governor and the Board are fraught with danger. What we can be absolutely certain of is that the cash rate will be reduced by 25bps by May this year. That said, the best policy is to cut by 25bps in March and adopt a clear easing bias. In these circumstances it is best to forecast good policy rather than angst over ‘second guessing’ what might happen.
