Inflation muddies the rate cut waters

The fourth quarter CPI data shows a rate cut in February is not a done deal, and financial markets are pricing accordingly.

The single best indication of the correct reaction to today's inflation data was in the financial market's response. In short, there was big disappointment – the market was, as I had correctly predicted, positioning for a very low number, and proved way wrong. Those economists forecasting super-low core inflation prints of around 0.2 per cent or 0.3 per cent – one was even angling for a negative number! – were frankly blown out of the water with the RBA's two core measures averaging 0.6 per cent (to one decimal place).

The Aussie dollar jumped from US 1.047 before the print to US 1.052 after. More tellingly was the reaction of Australian government bond futures. The benchmark 3-year government bond contract immediately plummeted 10 points from 96.74 to 96.64 as traders priced in higher long-term interest rates. The 30-day interbank futures contract also substantially reduced the probability of a rate cut in February, although it is still pricing in a better-than-even chance.

There is little doubt that today's inflation data creates more complications for the RBA. The average of the RBA's two main core measures – the trimmed mean and the weighted median – was 0.6 per cent. The Bloomberg consensus was 0.5 per cent, but all economists expected the risks to be skewed to the downside. (Remember also this is an inflation estimate produced using the ABS's much-improved expenditure class and seasonal-adjustment methodologies. So there are no excuses for the numbers).

As I have canvassed here in previous columns, more issues arose as a result of upward revisions to past data. In particular, both measures of third quarter core inflation were revised up from 0.3 per cent to 0.4 per cent. Crucially, this leaves Australia's 2011 calendar year core inflation rate sitting at, officially, 2.6 per cent, which is slightly above the mid-point of the RBA's 2-3 per cent target band. The risk is that the fourth quarter also gets revised up, and the numbers start looking a little ugly for Australia's central bank.

With interest rates now substantially below where they were in 2011, and the benefits of the remarkable Aussie dollar appreciation mostly behind us, it is hard to see how the RBA is going to be confidently forecasting the much lower inflation outcomes over the next two years it requires to justify more stimulatory policy than the one it already has in operation right now (with two pre-emptive rate cuts in November and December). Sure, if the economy starts growing clearly sub-trend, it could make the case. But today it is far more difficult, unless of course the RBA finds it easier to cut rather than raise rates.

There is, to be sure, much water to still flow under this bridge before the RBA meets again in February. But only a fool would refute the notion that a rate cut in February has become another line-ball – or in UBS's words "close" – call.


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