WEEKEND ECONOMIST: RBA's double trouble

Lock in a cut next week. The big question is, will the RBA move in November? With key China data expected to remain flat and CPI in check, there is certainly scope for a follow up.

The Reserve Bank Board meets next week on Tuesday. As we discussed in last week's note we expect the board will decide to cut the cash rate by 25 basis points from 3.5 per cent to 3.25 per cent.

As noted last week we also expect that the board will decide on a second move at the following meeting on November 6. We also expect a further cut of 25 basis points in the March quarter of 2013.

Those forecasts have been consistently held by Westpac since late May although we have had to push the final move back from end 2012 to early 2013.

While financial markets have moved in the direction of our views they are not generally shared by the economics community with the last poll of economists (September 21) showing that only five out of 20 expect a move in October with the median expectation being for only one more move in this cycle.

We do not intend to revisit our arguments for the October move.

They are well known and have been extensively covered in previous notes. Our interest in today's note is around the prospects of a follow up move in November.

The Governor's Statement following the expected decision on October 2 will be closely scrutinised. It would be encouraging if we saw something like: "The Board thought it prudent to see forthcoming key data on prices to reassess its outlook for inflation, before considering a further step to ease monetary policy."

That type of statement would, tying another move to the inflation print on October 26, be very encouraging. That statement, however, came in April 2012 before the cut in May but not at the same time as a cut. Scrutiny of the statements in November 2011 and May 2012 (the two meetings which were the first "legs" of a back to back cut) indicates that the governor is unlikely to give a strong signal of a follow up move in the October statement.

The bank has clearly been unnerved by the slowdown in the China data. Recall the governor's statement in September: "Some recent indicators have been weaker which has added to uncertainty about near term growth."

Between now and the November meeting, China will report September and October PMI surveys, the month-of-September activity and credit data, as well as third quarter GDP and the vitally important PBoC corporate, banking and consumer surveys. The spot iron ore price will also be reported 26 times.

Our view is that the production data will remain soft (GDP, industrial output itself and the output indices in the surveys) as the manufacturing sector continues to struggle through dual inventory cycles in heavy domestic output and light export output.

We anticipate that new information on credit supply will be sound but not extraordinary, while we expect that survey data on lending demand will show that second quarter was the cyclical trough. The infrastructure investment story should also look a little clearer, but the international trade picture will remain on the bleak side.

Bank funding costs have impacted monetary policy since the global financial crisis. We assess that the Reserve Bank's measure of the "neutral" overnight cash rate has fallen from 5.5 per cent to 4 per cent. That is one of the reasons why we assess the current policy stance as being only moderately expansionary and why we see ample room to move rates lower both in October and November. Even after a second cut in November a rate setting that was up to 100 basis points below neutral is not extreme when compared with previous easing cycles (2009 and 2001) when rates fell to 150 basis points and 125 basis points, respectively, below neutral at the low point of the cycle.

An interesting insight to bank funding was provided in the Reserve Bank's Financial Stability Review, which was released this week.

It notes that since 2008 the majors' share of funding represented by domestic short term funding has fallen from 20 per cent to 10 per cent and offshore short term funding share has decreased from 15 per cent to 12 per cent.

Simultaneously domestic customer deposits have increased, for the majors, from around 45 per cent of total funding to around 55 per cent, while term wholesale funding share has increased from 13 per cent to around 16 per cent.

For the majors, over that period, there has been a portfolio "shift" of around 13 per cent of funding from short term wholesale to term deposits (3 per cent) and customer deposits (10 per cent).

The Reserve Bank's estimate of the average "special" customer deposit rate is currently around 4.7 per cent compared to the 90 day bank bill rate (a reasonable proxy for wholesale short term funding) of 3.35 per cent.

Clearly, for the banks, this rebalancing of the funding mix has raised their funding costs. This increased cost due to the mix of funding complements the increased costs of domestic customer deposits and term wholesale funding.

A key issue for the November decision will be the print of the September quarter CPI on October 26. Our preliminary estimate for the underlying print is 0.8 per cent (0.3 percentage points contributed by the carbon tax) for an annual print of 2.5 per cent from 2.0 per cent in June. To date, the Bureau of Statistics has no plans to estimate the impact of the tax on the CPI.

We think the major direct impact will be for electricity prices to rise by an additional 10 per cent on top of the usual repricing we expect in the September quarter. "Gas and other fuels" are also expected to increase by around 9 per cent in the quarter. Typically, electricity prices increase by around 10 per cent in the September quarter so an expected 20 per cent increase would be an obvious impact from the carbon tax.

Equally, we would normally expect a modest 1 per cent increase in "gas and other fuels".

We have taken our estimate for other less important impacts on the inflation rate from the Treasury analysis of the impact of the tax on household spending. Other components of the CPI which can be expected to be affected are: food; fares; cars; communication; and holidays.

We assume that the Reserve Bank will do a similar exercise in "qualifying" the inflation result for the September quarter. If they do that analysis, we expect they will also assess the underlying measure at "around" 0.5 per cent for a benign annual result of 2.2 per cent, allowing adequate scope to ease further.

Of course, other global issues over the next few weeks will also impact the decision in November. Our hunch is that the risks are tilted towards disappointments rather than positive surprises given the lofty starting point.

Bill Evans is chief economist at Westpac.

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