On December 4 Westpac changed its interest rate forecast to expect 25 basis point rate cuts in both February and March.
At the time the market had priced in around an 80 per cent probability of one rate cut by end 2015. Markets are now in line with the Westpac view that there will be two rate cuts in 2015 although market timing is much more “patient” than our view with the first full cut priced in by April and another full cut priced in by the end of the year.
Market pricing for our February rate cut call is around a 25 per cent probability with a probability of 75 per cent for a cut by March. We continue to believe that the February rate cut is the most likely scenario. With markets now settling on the strong likelihood of a March move we see February as a much more attractive option for the RBA. With a February move it will be able to fully explain its reasons behind the move, including updating its inflation forecasts which are included in the statement on monetary policy, to be published on Friday February 6.
Recall that the RBA's last set of forecasts in November were based around a crude oil (Brent) price of $US86 compared to the current price of $US49. That fall in the oil price is going to markedly affect the print for the December quarter CPI (published on January 28) and expectations for the March quarter CPI.
Westpac is forecasting that headline inflation for the December quarter will print 0.1 per cent with underlying inflation at 0.6 per cent. That will push the annual rates down to 1.6 per cent (from 2.3 per cent in September) for headline and 2.3 per cent from 2.6 per cent for core inflation. Similar expectations for the March quarter (given the sharp further falls in fuel prices over the past month) will significantly change the RBA's inflation forecasts.
In November, the RBA forecast headline inflation to be 2 per cent for the year to June 2015 and 3 per cent for the year to December 2015. We expect those numbers will now need to be revised down to 1.5 per cent and 2.5 per cent respectively. Of course the core inflation forecasts are more important from a policy perspective.
In November the bank forecast core inflation for the year to June 2015 at 2.5 per cent and 2.75 per cent for the year to December 2015. We expect those forecasts should now be cut to 2.25 per cent and 2.25 per cent. The lower core measures will incorporate a somewhat weaker growth outlook (given the September quarter national accounts) which will further increase Australia’s negative output gap (recall that Australia’s growth has been below trend for 6 of the past 7 years and 2015 is expected to be another below trend year).
The indirect effect of lower fuel prices on, say, holidays both domestic and international and the cost bases of retailers will also impact the core forecasts.
Most importantly it should be reasonable for the bank to assume a lowering of inflationary expectations which will also impact upon core inflation forecasts.
We expect that core inflation to June 2015 will now print 2.25 per cent (from the bank’s 2.5 per cent in November) and 2.25 per cent (from the bank’s 2.75 per cent in November). That would mean that the bank would be changing its inflation narrative from expecting a move to the top half of the target band to prospects of a shift to the bottom half of the band – a significant turnaround.
If the bank has similar views then such a substantial change in the inflation outlook should be accompanied by a policy response. In that regard it is also important to recall that in December the Governor justified his steady rate policy on the basis that it had supported confidence and he would only contemplate a rate cut if it could be justified on the basis of a “positive" reason – he nominated lower inflation as just such a positive reason.
In short, the inflation report and the resulting impact on the bank’s inflation forecasts would provide it with an appropriate trigger to cut rates in February.
There is always the “barrier” that markets are not expecting a rate cut. However in recent days following “surprise” decisions by Canada, India, and Denmark markets are now discussing an RBA move. If the inflation report prints according to our forecasts then markets are likely to warm further towards our February view. Another very important justification for a February move is the current stance of policy as assessed by the shape of the yield curve.
Figure:1 shows that the past four easing cycles have all been triggered when the 10 year bond rate has moved close to the overnight cash rate. Long bond rates around the cash rate indicate that policy is unnecessarily tight.
Central banks could argue that in the era of QE the bond rate is not sending reliable signals about the outlook for growth and inflation although that would be a risky approach given the time honoured reliability of yield curve shapes in that regard.
In conclusion, we remain comfortable with our view that the RBA will cut in February while pointing out the importance of the inflation report, its impact on the bank’s inflation forecasts and the bank’s need to recognise the clear signals from the current shape of the yield curve, as well as the signal from the recent round of policy decisions by other central banks.
Bill Evans is chief economist with Westpac.