WEEKEND ECONOMIST: Rate cut by Christmas?

The futures market is pricing in a rate cut by December, but the inflation outlook indicates any pre-Christmas rate cut would likely be from a higher level than seen currently.

If you believe the interbank futures market, then there is now a better than even chance the RBA will be cutting the official cash rate by December this year. This is partly based on the market’s reading of the statement accompanying Tuesday’s increase in official interest rates, in which the RBA focused on the expected moderation in domestic demand and inflation. This is simply a reiteration of the RBA’s February Statement on Monetary Policy (SOMP) forecasts, but these forecasts look increasingly aspirational in character.

Wednesday’s December quarter national accounts confirmed that headline and non-farm GDP growth were both running above the RBA’s forecasting assumptions. Domestic demand, far from slowing, accelerated over the December quarter to 1.6 per cent quarter-on-quarter and 5.7 per cent year-on-year in real terms. The moderation in headline GDP growth largely reflected a 0.8 percentage point growth subtraction on the part of import volumes over the quarter and a 2.4 percentage point subtraction over the year. Contrary to the alarmist headlines, the growth in import volumes and the associated widening in the fourth quarter current account deficit is a sign of economic strength, not weakness. If you want to see what a narrowing current account deficit looks like in broader macroeconomic terms, look to the United States. No shortage of ‘improvement’ in their current account balance!

This week also saw the first bottom-up estimates for March quarter CPI inflation, pointing to an increase of 1.3 per cent quarter-on-quarter and 4.2 per cent year-on-year. With a nominal official cash rate of 7.25 per cent, this points to a real cash rate of only 3.05 per cent. Market-determined rates are significantly higher, with a real bank bill rate of around 3.8 per cent based on the likely March quarter CPI outcome, but real interest rates are arguably still too low.

The national accounts release also allows us to update our top-down inflation model. The model is based on the deviation from a long-run equilibrium price level entirely determined by the stock of broad money, an approach which also encompasses more conventional New Keynesian models such as those used by the RBA. The model points to a 0.8 per cent quarter-on-quarter increase in the RBA’s statistical measures of underlying inflation for the March quarter. While a moderation on the previous quarter, this still annualises above the RBA’s 2-3 per cent medium-term target range. The RBA needs these measures to hold at 0.7 per cent quarter-on-quarter or below for an extended period to be confident it has underlying inflation back under control.

This is not the first time this tightening cycle that financial markets have priced in future reductions in interest rates. Markets condition their view in large part on what the RBA says, or more importantly, what it does not say. Tuesday’s statement gave no explicit forward policy guidance, but neither did the February tightening statement. It was not until the February SOMP and Board minutes were released that the RBA bothered to mention its view that further significant increases in official interest rates would be required. The effort the market puts into interpreting the RBA’s statements is not matched by the effort the RBA puts into making them.

While an easing by Christmas is by no means impossible, this leaves markets grossly underpricing the risk of further intervening increases in the official cash rate. Any pre-Christmas reduction in rates would likely be from a higher level than seen currently.

This week’s data were otherwise a mixed bag. The moderation in retail spending in January will certainly be welcome to the RBA, but this follows a year in which total household consumption spending rose 5 per cent in real terms. Building approvals posted a weaker than expected bounce in January, suggesting no relief in sight to the national shortage of dwelling stock that is putting upward pressure on rents and inflation.

There is only one solution to the record lows in housing affordability: build more houses. More generally, the solution to Australia’s inflation problem is not demand management via monetary and fiscal policy, but augmenting the supply-side of the Australian economy. Any politician not talking about improving the supply-side of the economy is simply wasting our time.

Next week’s data will offer little relief on the inflation and interest rate outlook. We expect another strong 25,000 gain in employment in February, with the unemployment rate holding steady at the previous month’s 33-year low of 4.1 per cent. January housing finance is expected to decline 0.4 per cent month-on-month, which will feed into continued weakness in building approvals.

For its part, the Reserve Bank of New Zealand left its official cash rate steady at 8.25 per cent at its March Monetary Policy Statement. Governor Bollard said "we expect that the official cash rate will need to remain at current levels for a significant time yet to ensure inflation outcomes of 1 to 3 percent on average over the medium term". Like the RBA, the Statement struck a somewhat dovish note, saying that "the outlook for activity has deteriorated significantly in recent months, and is expected to contribute to easing inflation pressures". The RBNZ said that New Zealand "is entering a period of sub-trend growth," referencing weaker housing and net migration.

At the same time, the RBNZ raised its inflation profile, in part because the RBNZ has now incorporated the expected impact of the carbon emissions trading scheme into its central projection, which adds around
0.5 percentage points to inflation by 2010. Consequently, interest rates are expected to hold near current levels until mid-2009. Inflation is expected to peak around 3.5 per cent in the second half of 2008, before easing back below 3 per cent in the first half of 2009, but staying in the top end of the 1-3 per cent target range through to the second half of 2010.

We have previously pointed to New Zealand as a leading indicator for inflation and interest rate outcomes in Australia. Those looking for RBA rate cuts by Christmas from current levels in the official cash rate
might do well to look at experience across the Tasman.

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