Read between the lines for a rates rewind

Australia’s terms of trade and commodity prices are falling against an immovable Australian dollar, and recent Reserve Bank rhetoric suggests the odds favour a May cut.

Interest rate cuts are back on the table. 

The unfolding events globally, the free-fall in commodity prices, the persistent strength of the Australian dollar and the recent underwhelming domestic economic news means that the Reserve Bank is now likely to act on its monetary policy easing bias and deliver a further easing in monetary policy.

A 25 basis-point interest rate cut at the May 7 Reserve Bank board meeting is now more likely than not.

Here’s why.

Since the last Reserve Bank meeting a little over two weeks ago, the broad commodity price indices have fallen by between 5 and 10 per cent, while the Australian dollar is all but unchanged. This obvious and quite marked tightening in monetary conditions has occurred in concert with local news of a fresh three-and-a-half-year high in the unemployment rate and falls in business conditions and consumer sentiment, while the prior house price pick-up has stalled.

Globally, the performance of China has been surprisingly soft with the outlook universally downgraded, while the eurozone continues to spin its wheels in the sand of unmanageable sovereign debt. The US looks to be expanding at a decent clip, but there has been a slight bitterness showing up in some recent economic indicators.

Since the last local interest rate cut in December 2012, the Reserve Bank has maintained an easing bias. At every opportunity in recent weeks, Reserve Bank governor Glenn Stevens, deputy governor Phil Lowe, assistant governors Guy Debelle and Chris Kent have all vocally reiterated the propensity of the Reserve Bank to cut interest rates “if needed”.

The Reserve Bank staff would not be quite so vocal if an interest rate cut was a vague possibility rather than something that was under serious consideration and a top drawer option.

Having spent many years watching the Reserve Bank, suggestions this direct have usually been followed up with policy action. The recent news makes it likely that this will be the case again.

It is the commodity price fall that will be most concerning to the Reserve Bank and its inflation outlook. It will also be causing Treasury nightmares as it gets closer to finalising the economic forecasts that will underpin the budget.

A quick, admittedly back of the envelope calculation, suggests that Australia’s terms of trade have fallen a further 5 per cent since the start of 2013 bringing the run rate of the peak to trough decline to close to 20 per cent.

This is stripping away national income growth, knee-capping profit growth and will no doubt see the Reserve Bank revise its inflation forecasts lower.

There would be less of a problem had the Australian dollar followed the script and fallen to something nearer 90 cents or under 70 points on the trade weighted index.

But it hasn’t, which is why there is some urgency building on monetary policy.

With the Reserve Bank being an inflation targeting central bank for 20 years, the quarterly inflation data matter a lot. This is where the March quarter consumer price index, to be released next week, will be critical. All signs suggest the inflation rate will be 0.5 per cent for the quarter in both headline and underlying terms. The annual inflation rate, excluding the temporary and one-off effect of carbon pricing, is likely to be below 2 per cent, a rate under the bottom of the Reserve Bank target.

On inflation grounds alone, there is scope to cut interest rates. Add to that the recent economic and market news and it is easy to see why a rate cut or two is back on the table.

As the Reserve Bank has also noted a lot in recent times, the tightening in fiscal policy is still acting as a constraint on the domestic economy and the federal budget on May 14 is likely to maintain a tight rein on government spending. This is another reason why the policy rebalancing should be further tilted towards easy monetary policy given there will be on-going tight fiscal settings.

Back in January, I thought the Reserve Bank had cut interest rates sufficiently and that global conditions were improving to the point that no more rate cuts were needed. It looks like I was too optimistic and that these views and projections have been overtaken by recent global events.

While not much is certain in economics and policy forecasting, the outlook for the economy is definitely more problematic than it was even a month ago.

An interest rate cut will be heartily debated by the Reserve Bank board in May and if global conditions remain fragile and commodity prices weak in the weeks ahead, the odds will strongly favour an interest rate cut to 2.75 per cent, a level Australia has never seen before. 

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