Thursday, July 25, 2013

Why the RBA will cut rates

The RBA needs to cut interest rates. Its Board will sit down on 6 August to consider the appropriate level of interest rates with a trifecta of critical economic news before it. Those three vital elements are;
•There has been drift up in the unemployment rate to 5.7 per cent, which is a four year high and up from the recent low of 5 per cent just a year ago. The labour market forward indicators are all pointing down, suggesting a 6 per cent unemployment rate is just around the corner.
•Annual inflation, excluding the impact of carbon pricing, is a little uncomfortable at just 2 per cent and is threatening to break below the bottom of its target band. This is too low.
•Increasingly, there is problematic news from China, including yesterday with a weak manufacturing Purchasing Managers Index release, which builds on a range of warnings from officials about the imbalances in the economy. Many wise people are expecting China to record sub-7 per cent GDP in the second half of 2013 which, if realised, would be the slowest rate of growth in China in more than two decades.

These factors alone should ensure an interest rate cut next month and unless things change on these three measures, there will be more interest rate cuts after that.

To be sure, there are some encouraging signs for growth in the Australian economy. Consumer sentiment is above its long run average, house and share prices are moving higher, housing construction is slowly lifting and exports are strong. Add to that better news from the US economy and the interest rate hawks may have a few items to fire back at the doves.

But at the end of the day, it will be the unemployment rate, inflation and growth in major trading partners that determine what the RBA does, and that looks to be cutting the cash rate to 2.5 per cent.

Even before the disinflationary impact of the recent uptick in the unemployment rate has been seen on wages, the June quarter consumer price index confirmed inflation in the lower to middle part of the RBA's target band.

The RBA measure of annual underlying inflation was 2.4 per cent in the June quarter which equaled the second lowest inflation reading in the past decade. This annual inflation reading included around 0.5 percentage points from the introduction of the carbon price on 1 July 2012. Once this effect drops out the annual underlying inflation rate is likely to dip back towards 2 per cent.

In the June quarter, underlying inflation was a well contained 0.6 per cent, marginally above the 0.4 per cent rate of the March quarter for an annualised rise of 2 per cent in the past half year. This means the RBA can and will look to jobs and global risks for its policy guidance.

In terms of some secondary issues for the RBA Board, it will note that the Australian dollar is actually a little stronger now than at the time of its last meeting when it contemplated a rate cut. It is also clear that fiscal policy will remain a neutral to contractionary force as the government works to lock in the ever elusive budget surplus via spending cuts in the wake of ongoing revenue short-falls. An announcement by Treasurer Bowen to this effect is imminent.

There is also the issue of less than robust business confidence as the Dun & Bradstreet and NAB surveys show. While part of the drop in confidence is mining related, there is also no doubt an element of funk associated with Federal politics and the looming election. While the RBA cannot sensibly factor in the policy and confidence effects of the election until after it has passed, there is some prospect that once the new government is formed, there will be some bounce-back in business conditions, which of course would be a positive for growth.

With the CPI data confirming inflation is particularly low and showing no signs at all of lifting, the RBA can enhance its focus on the objective of full employment. In doing so, it seems a near certainty that it will deliver a cut in interest rates in August.

A cut will provide a further cash flow boost for small business and mortgage holders as well as providing a further incentive to ramp up spending and investment.

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