The minutes of the Reserve Bank's board meeting for April 3 have further strengthened the case for a 25 basis point rate cut at the next board meeting on May 1.
The minutes appear to indicate that the bank is more concerned with economic weakness in some regions and across sectors – referring to "sharp differences". It is also less upbeat about the labour market, noting that a decline in average hours worked and the participation rate were indicative of a softer labour market than that implied by the unemployment rate. We were also pleased to see that recognition had been given to the Westpac–MI index of unemployment expectations with the bank noting that household concerns regarding future unemployment were at their highest level since mid-2009.
There is even a more balanced assessment of business investment, with recognition that non-mining investment was likely to remain sluggish for some time.
The prospect of a CPI print on April 24 that might delay a rate cut seems low. Recall that the print for the quarterly CPI for the March quarter of 2011 changed market expectations substantially. The March 2011 quarter average core measure printed at 0.85 per cent for an annual growth rate of 2.25 per cent. The RBA responded in the statement on monetary policy with "further tightening of monetary policy is likely to be required at some point".
We are expecting an underlying print of 0.6 per cent for an annual growth rate of 2.4 per cent for the March quarter of 2012. Even a 0.8 per cent print next week would see the annual rate hold at 2.5 per cent; we would consider that to be acceptable for the RBA, given the sentiment around the real economy expressed above. The issue last year was that the quarterly number had risen sharply from 0.3 per cent in December to 0.85 per cent in March, and there was concern that inflation had bottomed and was set to rise quickly.
However, last year the degree of increase in the quarterly numbers was partly due to seasonality with our estimate of the adjusted seasonal pattern implying a 0.45 per cent to 0.7 per cent profile. Apart from seasonality, the main reasons for the sharp increase in the March quarter last year was around housing and the highly volatile "deposit and loan" component which jumped by 4.6 per cent in the quarter. The Bureau of Statistics (ABS) has now lowered the weighting of the deposit and loan component to 0.7 per cent, from 4.47 per cent.
The state of the housing construction sector and recent trends in housing costs point to more modest pressures from housing.
The ABS has also addressed the seasonality issues, with the 2011 December quarter average core measure being a much more reasonable 0.55 per cent than the seasonally affected 0.3 per cent December 2010 outcome. Overall, we expect that the risks of a CPI print that will "spook" the RBA are very low.
So that means that on May 1 the governor is likely to announce a rate cut of 0.25 per cent. The effectiveness of the cut from the perspective of the Australian economy will depend on its impact on overall financial conditions. That will include its impact on the Australian dollar and private sector loan rates.
Westpac expects that the Australian dollar is set to fall back to around parity with the USD by the third quarter. Markets are already fully pricing in the prospect of this rate cut so, theoretically, there should not be a significant impact on the currency. However, we have found over the years that there has been a disconnect between debt and currency markets, so the cut may well further weaken the AUD. Overall, however, our reasoning behind further weakness in the AUD is around global developments. We expect that the data read from China and its impact on commodity markets will continue to weigh on the AUD. Prospects for QE3 in the US are still live, but recent mixed signals from the US (particularly around a stronger than expected labour market) are likely to delay QE3 until beyond mid-year.
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.
Clearly the Reserve Bank is analysing these issues with the reasonable objective of assessing the likely impact of a change in the cash rate on overall financial conditions.
Since July last year, Westpac has forecast that the easing cycle was likely to entail 100bps in reductions in the RBA's cash rate with the final cut occurring in the September quarter of 2012. That forecast remains intact, with our expectation of a 25bp cut on May 1 to be followed by a further move in June or July. It is clear to us that the case for a second cut will be strong, despite the impact of the first cut on financial conditions.
Whether any further easing beyond those two cuts is required will depend upon the impact of those cuts on confidence, spending and employment. In part, those responses will be dependent upon the degree of easing in financial conditions.
Bill Evans is Westpac’s chief economist.