The minutes of the RBA's July meeting reaffirm the board's wait and see attitude. It is likely to be another few months before we see any deviation from this course.

On July 17, following the release of the Reserve Bank Board Minutes for the meeting on July 3 we revised our forecast for the outlook for monetary policy.

We noted: "These minutes have provided a more detailed picture of the current attitude of the Reserve Bank Board than we saw in the Governor's statement on July 3. However the message is the same. That is that the Board is in a 'wait and see' mode which seems likely to be sustained for some months.

Our view is that with interest rates, as described by the Governor as "a little below medium term averages" the case is already there that policy needs to be more stimulatory. However that relies upon our forward view of likely deteriorating prospects in the labour market (unemployment rate up to 5.75 per cent by year's end); underlying inflation dipping slightly below the 2 to 3 per cent target range; and the international outlook remaining fragile. Apart from interest rates other determinants of financial conditions are contractionary with fiscal policy tightening and the Australian dollar appreciating despite weakness in commodity prices. Funding pressures on the Australian banks due to strong competition in the domestic deposit market and wide spreads in the wholesale markets continue to pressure the banks.

As a result of all these factors we remain of the view that the overnight cash rate will eventually come down by 75 basis points to a low of 2.75 per cent. However, due to the Board's current policy disposition it is necessary to push out the timing of the first cut from August until the fourth quarter of 2012 where we expect two cuts in October/ November and December. Even lower rates are likely to be needed in the first quarter of 2013 with the final cut of 25 basis points coming in February/March.

That would put private sector interest rates around 100 to 120 basis points below neutral compared to 150 basis points below neutral at the lowpoint of rates in the last cycle in 2009. With fiscal policy and the exchange rate likely to be providing a source of tightening to financial conditions (quite the opposite to 2009) there would be no reason why rates would need to be reversed as quickly as they were in 2009 when the RBA began tightening only six months after the lowpoint had been reached.

While our rate call remains markedly more dovish than those recorded in economists' surveys our profile is less aggressive than market pricing.

Our estimate of market pricing continues to give a slightly greater than 50 per cent probability to a rate cut in August; an almost certain probability of two cuts by October; and a total of four cuts by March.

However we really don't assess that as a summary of the expectations about RBA policy from the market.

We expect that market pricing is a mix of monetary policy expectations and a 'safe haven' bid.

For me, the best example of how 'safe haven' influences market yields is in the US bond market. Currently 10 year US bonds are yielding 1.48 per cent but given that even the most dovish members of the Federal Open Market Committee are expecting the Fed to start tightening by late 2014 and they see the 'long term' Federal Funds rate at around 4 per cent (to be reached when unemployment returns to around 5 per cent) a 1.5 per cent 'risk free' return for 10 years could hardly be described as indicating a sensible view on the outlook for monetary policy over that period.

Of course, another test of the 'value' represented by that rate is in the real yield which brave investors in US bonds are being offered. US real bond yields are now negative – hardly a realistic return when growth in the US, while likely to be stuck in that 1.5 per cent to 2.0 per cent range for some years, is unlikely to contract for any sustained period.

As discussed, while US bond rates (along with German, Swiss and Japanese) are being distorted by the 'safe haven' bid so is the Australian curve. Australian three-year swap rates are at record lows and not only do the price signals from the short end of the curve imply an overzealous Reserve Bank easing but the middle of the curve also paints an equally unrealistic picture.

For example the swap curve is indicating that the overnight cash rate between, say, July 2013 and July 2014 is likely to average around 2.7 per cent; and between July 2014 and July 2015 around 3.0 per cent. In effect the curve, which is being distorted by this 'safe haven' effect is pointing to rates averaging around 150 basis points below neutral for the next three years – in our view, hardly a realistic assessment of the likely profile for monetary policy. While our economic views are probably more in line with that flavour of scenario than most others we would hardly expect such a profile as our central view.

The need for the first 'correction' to market pricing is likely to be apparent with the release of the June quarter CPI on July 25, next week. That 50 per cent probability of a rate cut in August, which market pricing implies, will be severely tested if our forecast for the CPI proves to be correct.

We do expect the annual pace of core inflation to dip below the 2 to 3 per cent target band. Due to the slight upside bias in some components of our bottom up forecast, we end up with a slight uptick in the pace of core inflation to 0.5 per cent for the quarter for the weighted mean (0.4 per cent for the quarter in Q1) and 0.6 per cent for the quarter for the trimmed mean (from 0.3 per cent for the quarter), lifting the average of the two from 0.4 per cent for the quarter in Q1 to 0.6 per cent for the quarter in Q2. However, with the 0.8 per cent for the quarter from 2011 Q2 dropping out, the annual pace of the average of the core measures drops to 1.9 per cent for the year, from 2.1 per cent for the year.

That read will be in line with the RBA's expectations and provides a basis for the further rate cuts which we expect later in the year. But, given the current more upbeat tone in the Board's minutes such a print will not, of itself, be sufficient to deliver a rate cut as early as August. We expect that market pricing will appropriately review its 50 per cent call with the announcement of that result.

Bill Evans is chief economist for Westpac.


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