WEEKEND ECONOMIST: Doves of May

As we expected, the Reserve Bank board decided to leave the cash rate unchanged at 4.25 per cent at their April meeting.

We believe that the case had already been made for a rate cut, but expected that the Bank needed more convincing. There is a very clear message in the accompanying statement that the Board decided to reserve any decision to cut rates until they have seen the next inflation report which will print on April 24.

A key reason why we forecast rates would be on hold was that we gave considerable weight to the high hurdle which the governor had set in previous statements, namely that "demand conditions (needed) to weaken materially” for policy to be eased further. That condition has now been consigned to the past tense as the governor discusses it as a former but not current reason for holding rates steady.

In looking forward he now refers to output growth being "somewhat lower than earlier estimated”. From our perspective while the word "somewhat” might seem to be a modest choice, that is typical ‘central bank speak' for a surprise. Currently we forecast that underlying inflation will print at 0.6 per cent for the March quarter-on-quarter with the annual rate falling from 2.6 per cent to 2.4 per cent. That should provide ample scope for the rate cut which we have always expected for May, with a follow-up move in July.

In previous statements the trigger for a rate cut was emphasised to be a sharp deterioration in global conditions. This concern is now easing. The one exception is around China. Rather than describing Chinese growth as "quite robust” the Governor now describes China as having slowed and argues that it has moved into a phase where it will produce "a more measured and sustainable pace in the future”. That is a striking change. Note that in other official documents the Bank has inserted a caveat along the lines of ‘policy caused this and policy can fix this'. Here we have a hint that the Bank's medium-to-longer-term view on Chinese is for a more sedate, possibly flattish trajectory.

The same paragraph ends with the definitive statement "Australia's terms of trade has peaked”. World growth continues to be described as below trend with Europe recording very weak outcomes and the US only showing "a moderate expansion”. Despite improving conditions in global capital markets the Bank (appropriately) remains cautious about the potential for adverse shocks from Europe for some time yet.

We are disappointed that the Bank continues to talk about little change in the unemployment rate. We estimate that without the recent falls in the participation rate the unemployment rate would now be around 5.75 per cent rather than the official 5.2 per cent and be painting a much bleaker but realistic picture of the labour market. This is a clear demonstration of the dangers of only relying upon the unemployment rate as a measure of labour market conditions.

Other assessments of conditions are unchanged: "credit growth remains modest”; "the housing market remains soft”; and "the exchange rate has remained high”. The discussion on inflation emphasises the cautious nature of this decision. Inflation is still expected to remain in the 2-3 per cent range over the coming one to two years but confirmation is needed from the next quarterly series. We see minimal risk of a ‘rogue' high number which would eliminate the possibility of rate cuts, despite the upward seasonal bias in the March quarter. Even though the Governor notes that "data on demand and output” will also influence the decision in May we would be surprised if a benign inflation print does not ensure a rate cut.

The slowdown in momentum in the fourth quarter appears to be persisting in the first few months of 2012 with weak reports for retail sales, building approvals, confidence, both business and consumer, plus the February employment report. We are also confident that the inflation print will be benign, particularly now that the major source of volatility in inflation – deposit and loan facilities – has been effectively eliminated from the series. In keeping with our forecast back in July last year that the low point in this cycle will be 3.75 per cent, we expect a follow-up move by July, if not earlier. Whether rates go even lower will be dependent on the response of the commercial banks to the RBA's decisions. In February the commercial banks offset rising funding pressures by increasing mortgage rates by 10 basis points. While the governor dismisses that widening as insignificant, further widening in these spreads would increase the challenge for the RBA.

We have also noticed in our consumer sentiment reports that ‘independent hikes' have had an impact on confidence. Accordingly, any significant slippage in the degree of pass through would mean that the RBA's final target would need to be even lower than 3.75 per cent. We have no particular insight into the proposed policies of the banks in response to the expected rate cuts. The facts are that since mid 2011 the cash rate has been reduced by 50 basis points and the banks have reduced the standard variable mortgage rate by 40 basis points.

In a recent speech, RBA Assistant Governor Debelle discussed the links between bank funding costs and the RBA's overnight cash rate, noting that "the cash rate is clearly not the only determinant of the rate structure in the economy”. He points out that "term premia play an increasing role” as banks seek to lengthen the maturity of their liabilities; "risk premia impact funding costs” as lenders to banks assess potential credit risk; and competitive forces play an important role in deposit pricing. He notes: "competitive pressures in the deposit market and risk premia for the banking sector globally have risen substantially.”

The impact of competitive pressures on deposit pricing has been particularly marked as banks have raised their share of deposit funding from 40 per cent in 2007 to 52 per cent in 2012 with most of this increase occurring in term deposits going from 30 per cent to 44 per cent. He notes "term deposits pay higher interest rates than other forms of deposits”. Furthermore he notes that there has been little growth in the value of the low-interest transaction style deposit accounts. Overall, the RBA estimates that while the cash rate has fallen by 50 basis points since mid 2011 the average interest rate on deposits has only declined by 25 basis points.

Calculating the effective increase in the cost of long term wholesale debt is complicated by maturity structures which will differ across banks. Overall, the RBA calculates that the major banks' outstanding long term wholesale debt has risen by around 25 basis points relative to the cash rate over the past year. The RBA study concludes that: "Since the middle of 2011, there has been a further increase in banks' funding costs relative to the cash rate of the order of 20-25 basis points.”

Of course this number is an average for the system and necessarily reliant on a range of assumptions which may or may not be valid in the case of individual banks. However, generally, with mortgage margins widening by ‘only' 10 basis points over that period the RBA study at least highlights the risk of further slippage as banks may seek to recover higher funding costs.

By highlighting explanations for the weakening of the link between the cash rate and banks' funding costs the RBA study also alerts market watchers to the issues that banks will be assessing as they respond to what we expect to be two more cuts in the cash rate over the near term.

Bill Evans is Westpac's chief economist.