WEEKEND ECONOMIST: Rates relaxation

The Reserve Bank board meets next week on May 1.

The print of the March quarter consumer price index number puts a May rate cut beyond doubt.

Headline inflation printed just 0.1 per cent for the quarter to be only 1.6 per cent for the year. The Reserve Bank's average measure of the trimmed mean and weighted median printed 0.35 per cent for an annual read of 2.15 per cent down from 2.55 per cent in the year to the December quarter 2011. That puts the key underlying inflation measures for the Reserve Bank into the bottom half of the target band of two to three per cent.

While the 16 per cent fall in fruit and vegetable prices was the key driver of the incredibly low headline and seasonally adjusted headline, the trimmed mean and weighted median measures were also significantly lower than expected.

Our take on that was the lower than expected reads on the major items (house purchase, utilities, education, and health), along with some weaker reads on "demand sensitive" components. Of particular interest here is the house purchase series which has the highest weight in the CPI and is almost always captured in the trimmed mean.

The (rare) negative read on house purchase emphasises the parlous state of the housing construction sector and certainly that sector's need for some interest rate relief.

Our call for the RBA rate cycle, which we first released in July last year when the cash rate was 4.75 per cent, has been a low point of 3.75 per cent in the September quarter. Our call for a move in May of 25bps and another in June/July can now be firmed up with a June timing for the second move being our clear preference.

We have argued that the need for further cuts will be assessed in light of the impact on the economy of the change in financial conditions resulting from the cumulative 50bps of easing. With the inflation constraint now removed for the RBA it will be free to pursue cuts beyond the 50bps we envisage for the near term.

Markets have moved to price in a total of 100bps in cuts from this point. The CPI result would bolster the markets' confidence. For our part, any change to that 3.75 per cent low point will require further discussion and consideration but, as we have argued in the past, the risks to the current forecast are clearly to the downside. Markets are also "flirting" with the idea of a 50bp rate cut in May. We would tend to dismiss that prospect given the general cautious approach of the RBA. While we would not argue with such a decision, given that our view was that the case had already been made for a cut in February this year, we expect that the RBA will prefer to assess the impact of the rate cut on financial conditions and confidence before it moves the full 50bps.

This caution would be given some impetus from the tradeable/non-tradeable breakdown in the CPI. Recall that the RBA has consistently noted its concern for the non-tradeable components of the CPI to slow. It has argued that over-reliance on the Australian dollar to contain inflation pressures represents risks in the event of a reversal or even stability of the AUD.

Evidence of a slowdown in non-tradeable inflation pressures would be required in the medium term. For the March quarter CPI, the tradeable component fell by 1.4 per cent while non-tradeable increased by a solid one per cent to print an annual rate of 3.6 per cent compared to tradeable inflation of –1.5 per cent.

In last week's note we emphasised why the risks to our 3.75 per cent forecast were clearly to the downside. That risk revolved around the RBA needing to assess the impact on financial conditions and the response of economic agents to the two rate cuts, which we had forecast for the near term.

We pointed out: "Implications for private sector rates are also important from the perspective of overall financial conditions. For banks and other financial intermediaries, it is reasonable to assume that, at least over the medium term, the pricing of their assets will be significantly but not exclusively influenced by their cost of funding.

In that regard, the Reserve Bank has made a significant contribution to the debate with its recent Bulletin article, "Banks' Funding Costs and Lending rates". The bank notes that the most important influence on banks' lending rates is the cost of funding (other factors cited are credit risk, liquidity risk and growth strategies).

The bank asserts that the cash rate is the primary determinant of funding costs, although risk premia and competitive pressures, which are not affected by the cash rate, are also significant. The study finds that while deposit rates and yields on bank debt have generally declined since mid-2011, the declines have not matched the decline in the cash rate over that period.

A key explanation for the weakening of the link between bank funding costs and the cash rate has been the rebalancing of the composition of funding. There has been a shift away from short-term wholesale funding towards long-term wholesale funding and customer deposits. Of course, short-term wholesale funding costs are more directly responsive to the cash rate.

In summary, the bank estimates that since the middle of 2011, there has been an increase in banks' funding costs relative to the cash rate of the order of 20–25bps."

The March quarter CPI print might raise the target in the bank's thinking for the necessary easing in financial conditions. That would not dilute the need to assess financial conditions and to monitor the response of the economy to that easing in financial conditions in the light of the two consecutive cuts which we expect. However, it does give greater emphasis to our assessment that risks to our end cash rate of 3.75 per cent are to the downside.

Bill Evans is Westpac's chief economist.