We are maintaining our call for a low in the Reserve Bank's overnight cash rate of 2 per cent by the March quarter of 2014. That would indicate three more cuts of 25 basis points each from the current 2.75 per cent.
Market pricing has fluctuated markedly over the last few months with current pricing settling around almost two cuts by that time. Only recently markets were questioning whether indeed any more cuts would be forthcoming so it is difficult for agents to base medium term decisions purely around market pricing.
We expect the next cut is likely to occur at the bank's next board meeting on August 6. Markets and most commentators were unnerved by the minutes of the bank's July board meeting which noted: "Given the exchange rate adjustment that was occurring, and with substantial degree of monetary stimulus already in place, members assessed the current stance of policy to be appropriate for the time being."
That statement was assessed to imply no urgency but from our perspective it is simply a central bank making the case for the current decision rather than providing any forward guidance. It is dangerous to confuse a strong justification for a current decision with forward guidance.
Another aspect of the minutes which discouraged speculation about a move in August was around: "Members noted that it was possible that the exchange rate would depreciate further." Of course since that board meeting on July 2 the exchange rate has actually increased a little by around US0.5 cents. We expect that the exchange rate is likely to drift even higher over the course of the next two weeks.
Two key explanations for the fall in the Australian dollar over the last two months have been around speculation of US tapering in their bond purchase program and uncertainty around developments in China. In his testimony to Congress, Federal Reserve chairman Ben Bernanke was at pains to emphasise that the tapering plans would only be implemented if the US economy developed along the lines indicated in the Fed's forecasts. The Fed is currently forecasting GDP growth of 2.5 per cent and 3.25 per cent in 2013 and 2014 respectively whereas we expect growth of 1.6 per cent in both years. Note that annualised growth in the first half of 2013 is now expected to be 1.4 per cent.
Note also that the chairman emphasised the importance of inflation in his speech.
In a separate note we pointed out: "The overall speech emphasises the Fed's dual objectives – employment and inflation (2 per cent objective). Markets have tended to mainly focus on the state of the labour market. The chairman consistently notes the importance of inflation moving towards the 2 per cent target. However, whereas the official Fed forecasts for June show a modest improvement in the outlook for unemployment relative to March there is a marked change in the forecast for inflation. In March the Fed forecast inflation in 2013 to be 1.3-1.7 per cent (core 1.5-1.6 per cent). The June forecasts are 0.8-1.2 per cent (core 1.2-1.3 per cent). Inflation is noted by the chairman to be currently running at 1 per cent. He emphasises the prospect that very low inflation poses risks to economic performance and increases the risk of outright deflation. He also noted that even if the unemployment rate reached the threshold 6.5 per cent, 'the Committee would be unlikely to raise the funds rate if inflation remained persistently below our longer run objective'."
Of course we cannot discount more turbulence in the Chinese data flow but expect it is reasonable to assume that markets have already discounted a high degree of bad news already.
The board also pointed out that "the inflation outlook, although slightly higher because of the exchange rate depreciation, could still provide scope for further easing".
While the exchange rate effect is likely not to register until the September quarter (for fuel) and beyond for other imported goods the inflation print for June quarter, which is set to be released on July 24 is likely to further support the case for a cut in August.
We expect headline inflation to print 0.5 per cent and the average of the two underlying measures (trimmed mean and weighted median) to also print 0.5 per cent pushing annual underlying inflation down from 2.4 per cent to 2.3 per cent. A similar result for the September quarter would see annual underlying inflation drop to around 2.1 per cent as the carbon price effect on core inflation from the September quarter last year drops out.
We expect that in an economy where domestic demand is weak (we forecast domestic demand to grow by only 0.7 per cent in 2013) the ability of importers to pass through any price increases will be limited, certainly containing any inflation pressures from the fall in the Australian dollar.
When assessing the impact of the lower Australian dollar it is also important to consider its impact on financial conditions. While a lower currency can rebalance the mix of growth its impact on demand overall will be related to its impact on financial conditions. To that effect it is relevant to assess the movement in the currency relative to the terms of trade. Export commodity prices are not the only component of the terms of trade but by far the most important. The board minutes note that, "in Australian dollar terms Australia's commodity export prices had changed little over recent months because of the recent exchange rate depreciation".
Lower currencies stimulate economies when financial conditions ease. Due to this marked offsetting effect from export commodity prices the easing in financial conditions has been significantly less than implied by the fall in the Australian dollar. Market estimates that the fall in the Australian dollar is equivalent to 5 basis points in rate cuts seem way overstated given the offsetting reduction in the terms of trade.
The minutes also marked a more certain and more downbeat outlook for the mining sector than we saw in the June minutes. "Mining investment was near its peak" (June); "(mining investment) looked to be close to, if not past, its peak" (July) and "considerable uncertainty about mining investment beyond (the next year)" (June); and "planning and development work related to future projects had declined significantly since the previous year" (July).
Concerns around the labour market remain: "Forward looking indicators of labour demand implied only modest growth in employment in the months ahead." Of course this meeting preceded the print of the increase in the unemployment rate from 5.5 per cent to 5.7 per cent.
Other 'surprises' since the July board meeting would have been: "measures of sentiment declined slightly for .... mining and manufacturing". The recently released NAB Business Survey showed a very sharp decline in retail; mining and manufacturing confidence.
"Retail sales were flat in April though ... liaison contacts suggested that sales rose modestly in May and June" - the May retail trade report showed April sales being revised down from 0.2 per cent to -0.1 per cent and March from -0.4 per cent to -0.6 per cent while May, itself, only printed 0.1 per cent – overall a significantly weaker picture that implied by the minutes.
In summary we expect that the case for the August rate cut is strong despite market doubts. The board minutes, recent global developments, a benign inflation report and prospects for a more stable Australian dollar all point towards a move in August.
In addition, the entrenched weakness which we see extending for some time in the Australian economy in the context of very low inflation and weak global growth support our call for further rate cuts in both the December and March quarters.
Bill Evans is Westpac's chief economist.