From Bill Evans at Westpac:
The Reserve Bank board meets next week on November 3. We expect the board will decide to keep rates on hold.
Markets have lifted the probability of a cut from 25% to around 65% following the release of the September quarter Inflation Report. In the Report core inflation for the September quarter printed 0.3% (both Trimmed Mean and Weighted Median).
That compared with market expectations of 0.5%.Annual core inflation is now printing 2.1% (Trimmed Mean) and 2.2% (Weighted Median). Note that in the August Statement on Monetary Policy the Bank forecast core inflation at 2.5% for the year to December 2015. At that time the six months to June 2015 had printed 1.6% for both Trimmed median and Weighted Median. That forecast implied that the Bank was expecting core inflation over the second half of 2015 to print 1.2% – around 0.6% per quarter. That is around twice the print for the September quarter.
As such the September quarter read will come as a significant surprise. There is a precedent for this shock result. The Trimmed Mean measure for the September quarter last year also surprised on the low side at 0.3% (Weighted Median at 0.5%). We expect that the Trimmed Mean is given a greater weight in the eyes of the authorities than the Weighted Median – recall that other countries (e.g. US) only talk of Trimmed Means when they use sophisticated measures for core inflation. That measure pushed annual Trimmed Mean down from 2.8% to 2.4%. This measure has pushed it down from 2.2% to 2.1%.
Despite that “shock” on the Trimmed Mean in September last year the Bank held rates steady at the November board meeting and even maintained the call that the most appropriate approach to policy was a “period of stability”. At that time the Bank was forecasting underlying inflation to print 2.25% for the year to December 2014 but anticipated that lifting to 2.5% in the year to June 2015 and to 2.75% in the year to December 2015. So in the near term the Bank took notice of the low print but because of the fall in the AUD expected inflation to lift one year out. With the AUD having fallen even further it will still be mindful of some eventual upward pressure as demand conditions firm.
The Bank will now revise down its forecast for core inflation to December 2015 from 2.5% to 2.25% (just as it had in November last year) but that will not be sufficient to change policy. We expect it will still hold its forecast for 2.5% through 2016 due to a combination of an expected lift in demand and a lagged impact from the fall in the AUD. Note that its growth forecasts in the August SOMP imply growth momentum in the second half of 2016 of around 3.75% (annualised).
Last year the surprise low print for the Trimmed Mean did not prompt the Bank to move from “period of stability” to cutting rates in February. It was the growth outlook.
The drop in core inflation was known at both the November and December meetings but it was the surprise slump in growth that was recorded in the September quarter GDP report that printed the day after the December board meeting that prompted the rate cut.
In February when it cut rates it revised down its growth forecasts for 2015 from 3% to 2.75% and noted:” growth overall is now forecast to remain at a below-trend pace somewhat longer than had earlier been expected.
Accordingly, the economy is expected to be operating with a degree of spare capacity for some time yet, and domestic cost pressures are likely to remain subdued and inflation well contained”.
The emphasis here was clearly on a deteriorating growth profile rather than a low inflation print. In fact the December quarter Trimmed Mean showed a rebound to 0.6% (Double the September print). Recall that the forecasts at the February board meeting were for growth at 2.75% in 2015 – below trend despite a rate cut and an assumption of a follow up rate cut by May.
Could the Board be confronted by another below trend growth forecast in 2016 which would trigger another rate cut?
It seems unlikely.
Firstly the starting point is higher than we saw in February. The November growth forecast for 2015 was 3% – bang on trend whereas the August forecast for growth in 2016 is 3% (now 0.25% above trend, since trend has been revised down).
To forecast below trend growth in 2016 which would be associated with a rate cut the Bank would have to forecast growth in 2016 of 2.5% down from 3%.
The major “growth negative” development since the August SOMP has been the soft GDP print for the June quarter. We do not think the Bank was particularly surprised by the weak 0.2% print for GDP growth in the June quarter (largely driven by seasonally weak exports). Certainly the rhetoric in the October minutes was, on balance, more positive than we have seen, particularly around the labour market. The view has shifted over the last six months from unemployment rate rising through 2016 (May SOMP); to now having peaked (August SOMP); to possibly falling (October minutes).
The one big change which may prompt a major downward revision to growth would be an anticipated impact from the recent independent increase in bank mortgage rates. Because most borrowers (Westpac has reported around 70% of its borrowers) are ahead on repayments the cash flow effect of the banks’ increase will be muted.
The major impact would be through confidence. The weekly Morgan/ ANZ Consumer Sentiment Index , which printed after all majors had raised rates hardly moved this week. This is a volatile measure (as would be expected with weekly series) but it is the only one available in the window before the Board meeting. It’s result would be inconclusive from the Bank’s perspective and certainly not sufficient to justify a large mark down in the growth outlook.
Conclusion
We still expect the RBA to be on hold at its meeting next week. The surprise drop in the inflation measure is not unique and, in the past, the Bank has looked through a one off number.
The motivation for cutting next week would be a significant downward revision to the growth outlook. The data flow and the RBA’s recent commentary does not point to such an event. Consequently we expect rates to stay around the current record lows.
From an economic standpoint I’m inclined to agree. The data flow has been solid if unspectacular and they will want to wait to ensure that they have the Sydney and Melbourne bubbles contained before cutting again. It makes sense to at least hold until December. They can signal an intent to ease in the November SoMP as well.
But psychologically the bank faces an interesting choice. If it does not cut before year end then it is a distinct possibility that by February the housing market will be stalling. The bank will not want it to slow completely given that is our only economic bright spot.
Second, if it cuts next week it can squarely blame the banks (or to put it more diplomatically, declare that macroprudential is working) while taking out some economic insurance but not be held accountable if housing fires up again.
I’m still tossing up this meeting, which is really just a parlour game, rates are going lower, sooner rather than later.
