Time to cut along the rates bias

Earlier views that past rate cuts were enough should be revised. The Reserve Bank must cut at least 25 bps more if it’s to meet inflation targets.

Since the last meeting of the Reserve Bank board five weeks ago, there has been a range of news on the economy that suggests monetary policy is too tight. This means a 25 basis point interest rate cut tomorrow is a minimum requirement if the clear signs of disinflationary economic sluggishness are to be turned around.

Both the Reserve Bank board and I were of the view in the early months of 2013 that earlier interest rate cuts were percolating through the economy, that global economic conditions were on the improve and that monetary policy was easy enough to see real GDP growth lock in at 3 per cent or a little more. This economic upturn was likely to underpin inflation, which would see it increase to be more aligned to the middle of the target range.

We were both wrong.

Since the last reduction in the official cash rate in December 2012, the Reserve Bank board has maintained its so-called bias to cut interest rates. This has been a prudent approach.

The time to act on that bias has now arrived for the following reasons. 

Critically important is the fact that the Reserve Bank is already close to missing the inflation target. The impact of the carbon prices is still being seen in the annual inflation rates and if the effect of this one-off and temporary impact is looked over, both headline and underlying inflation are at or below 2 per cent and disconcertingly, both are falling.

The current available Reserve Bank forecasts for inflation to remain within the target band over the next 18 months are obsolete. Actual underlying inflation in the March quarter was equal to the second-lowest reading ever recorded (according to historical records back to 1982).

Factoring this into the base for the inflation forecasts and noting the persistently high Australian dollar, which is above $US1.03 this morning, the grounds are there for lowering the Reserve Bank's inflation forecast.

Added to that mix is up-to-date news of a gentle, but increasingly disconcerting, rise in the unemployment rate, strong productivity gains and moderate wages gains. Using that information, reasonable people would come up with a forecast for annual headline and underlying inflation of around 1.5 per cent over the next 18 months.

In the past two years, the Reserve Bank has noted the contractionary influence on economic growth from fiscal policy at both the state and federal level. I am sure that Treasury Secretary Martin Parkinson, when having his say around the board table tomorrow, will confirm that the fiscal contraction remains in place with the details to be confirmed in the budget next week.

Indeed, it is likely that public demand will make a zero contribution, at best, to GDP in 2013-14, having sharply contracted in the current fiscal year.

There are other points to note.

House prices edged lower in April to unwind what now looks to be a short-term lift in the March quarter. The risks surrounding a strong house price rebound look to have passed.

In addition, the information from the recent Dun & Bradstreet surveys of business and consumer financial stress, together with the dip in business conditions highlighted in the recent NAB survey, suggest growing risks of a sub-trend growth performance in the second half of 2013.

These risks can be reduced with a prudent rate cut tomorrow.

The actions of the Reserve Bank's central bank counterparts around the world provide a sobering backdrop to the current Reserve Bank forecasts for global growth. Ben Bernanke has opened the possibility of adding to the already high level of quantitative easing in the US; Mario Draghi is considering negative interest rates as things are so dire in the eurozone while Haruhiko Kuroda in Japan has worked to stimulate the economy with aggressive quantitative easing. Even Duvvuri Subbarao is cutting interest rates as the Indian economy hits a pothole.

The policy of least policy regret for the Reserve Bank board tomorrow seems skewed heavily towards a rate cut.

The board needs to consider the infinitesimal risks of an inflation blowout if it delivers a 25 basis point easing. The risk to growth, jobs and yet lower inflation by not cutting seem much greater.

In all of this, I have not mentioned the outlook for mining investment and then commodity prices. These are critical issues in the more medium-term outlook for the economy and the signs are increasingly pointing to a topping out of the mining investment boom and flat commodity prices at best, sharp falls at worst.

It remains the case that further rate cuts will be required in the months ahead. Certainly if conditions soften for jobs and wages and the Australian dollar fails to track commodity prices lower, the inflation rate could become unnecessarily low.

But that debate is one for the June board meeting and in the months beyond. For now, the case for a 25 basis point cut is overwhelming.

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