Much as I would like to stir the pot by suggesting that the Reserve Bank of Australia should and will cut interest rates on Melbourne Cup day, I actually agree with market expectations that it’s now a relative long shot. What’s more, to my mind, the case for a further rate cut anytime soon is quite weak.
The RBA may well cut interest rates again in the first half of 2017, but it will first need to be convinced that its hopes of annual underlying inflation reaching 2% by June next year are unlikely to be realised. In turn, that may take at least one – but likely two – more CPI reports, suggesting the next window for a rate cut could be as early as February, but most likely May. And of course, all this assumes the economy continues to chug along at a close to a trend pace such that the unemployment rate holds near current levels around 5.5%.
Let’s recall what’s happened this past year. We entered 2016 with annual underlying having eased to 2% by the December quarter 2015, and in its February Statement of Monetary Policy (SMP), the RBA indicated it was expecting underlying inflation to hold at 2% by the June quarter 2016. Then came the shock March quarter CPI, which saw annual underlying inflation drop to 1.5%.
Gobsmacked, the RBA took on board this number and – together with a navel gazing re-think of its medium-term inflation outlook (particularly in light of stubbornly weak wages growth and business liaison suggesting intense retail competitive pressures), it slashed it forecasts for annual underlying inflation over the next two years from 2.5% to 2%. It now predicted annual underlying inflation would only be 1.5% in the June quarter, and pushed out its expectation for when underlying inflation would reach 2% another year until the June quarter 2017.
The RBA cut rates in May based on these revised forecasts, which were publically released a few days later in the May SMP. Once underlying inflation was confirmed at only 1.5% in the June quarter CPI report, the RBA then cut rates again in August – completing a 0.5% adjustment down in rates to reflect the 0.5% downward revision to its medium-term inflation outlook. Notably, however, the RBA did not revise down its inflation forecasts further in the August SMP, which is why rates were left on hold in September and October.
Heading into the November meeting, the key issue was whether the September quarter CPI would, as with the March quarter, surprise on the downside – which might have forced the RBA to revise down its inflation forecasts even further and, going by its May precedent, likely cut rates on Melbourne Cup day.
As it turned out, the CPI outcome was broadly in line with RBA expectations: allowing for rounding, that RBA has likely concluded annual underlying inflation held at 1.5% in the September quarter, meaning the RBA is unlikely to revise its inflation forecasts again when the November SMP is released a few days after the Board meeting.
With the inflation outlook unchanged, there’s no case to cut rates in November. It’s that simple.
That said, as noted above, the RBA’s current inflation projections – likely retained in the November SMP – do contain the expectation that annual underlying inflation will rise to 2% by the June quarter next year, largely because of a firming in labour costs.
Barring any sudden shock to the economy, it’s whether this forecast turns out to be correct or not that will likely determine whether the RBA cuts interest rates again. And as noted above, I doubt the RBA will have enough convincing information to make that call at least until May next year, following the March quarter 2017 CPI result.
Of course, all this begs the question: what will happen to inflation? Given the now stubbornly high $A, likely continued intense retail sector competition, and the likely easing in housing costs pressures (especially rents) over the coming year, a lot is riding on higher labour costs to push up inflation. I suspect underlying inflation will struggle to get back to 2% that quickly.
The bigger question is then how newly installed RBA Governor Phillip Lowe reacts. While he has recently emphasised a desire to interpret the 2 to 3% inflation target flexibly – noting its medium-term nature – he’s also mindful of the risk of letting inflation expectations dropping too far if stubbornly low inflation persists too long. That would make it even harder to get inflation back up again.
All that leads me to conclude there’s still a good chance of a rate cut in 2017.