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Will 'noflation' prompt an Aussie rate cut?

Macro 5 minutes to read

Summary:  Tempting though it may seem, an Australian rate cut next month is unlikely, given that the central bank is yet to adopt a formal easing bias, there's a controversial election and the labour market remains in good shape.

Last week’s damning inflation report showed Australian inflation has slowed significantly in the first quarter of this year. Consumer prices were flat on the quarter as the lucky country has not managed to escape the pervasive disinflationary environment evident globally. The first quarter's “noflation” print pushed the annual rate down from 1.8% to just 1.3%. The trimmed mean inflation, an important measure of core inflation for the Reserve Bank of Australia, softened to an annual rate of 1.6% below the RBA’s forecast of 1.8%.
Source: Bloomberg
Following this weak inflation report, that missed economists' expectations, the conversation has shifted from “if” the RBA will cut the cash rate, to when will it cut the cash rate, which currently sits at 1.5%. Many economists and forecasters, previously tipping the RBA to remain on hold, have now jumped on board the rate cut ship. 

In terms of market pricing, the odds of a rate cut have also increased following weak CPI data, as bank bill rates and the yield on 3-year notes has plummeted. There is now an 89% chance of two rate cuts this year, which has increased from 62% odds prior to Wednesday’s inflation report as per implied probabilities ascertained from overnight index swaps. For next week’s RBA meeting market pricing is less definitive with futures indicating a 48% chance of a rate cut at next week’s meeting but OIS only tipping a 44% chance of a rate cut next week. Nonetheless the idea of a pre-election rate cut is gaining traction.

So, will the RBA cut in May? We have long forecast that the RBA will eventually have to cut the cash rate, as pervasive stagnant wage growth means income growth for the average person is not enough to offset the negative wealth effect felt as house prices continue to deteriorate. As house prices diminish due to high debt levels, people save more, and consumption growth drops off.

Private consumption is a big driver behind the Australian economy and historically represents around 60% of GDP. This means the outlook for household spending is very important in determining the future path of the Australian economy. As we have previously highlighted, the outlook surrounding the consumer in Australia remains fragile, which will see the RBA forced into a corner where there is no option but to cut rates, despite its reluctance, but May is likely too soon.

The RBA stated in its board meeting minutes earlier this month that  "Members also discussed the scenario where inflation did not move any higher and unemployment trended up, noting that a decrease in the cash rate would likely be appropriate in these circumstances,". Here the RBA clearly states the conditions for cutting the cash rate – inflation remains lower than expected and that the trend in unemployment starts rising.

Whilst the first part of this condition has been met, with inflation remaining below the central bank's 2-3% target band, the second condition is yet to materialise. Employment remained solid in March with 25,700 jobs added, even though the unemployment rate ticked up to 5% due to increased participation. Before moving on rate cuts, given that the RBA has been so reluctant to adopt even a neutral bias on the outlook for interest rates and that it has long pointed to the strength in the labour market being key to its outlook, the RBA will wait until signs of labour market softening are evident before they fully capitulate and move to cut rates. This would rule out a May rate cut.

We don’t necessarily need to see unemployment move up in a big way, given that it has remained the RBA’s pillar of strength in the domestic economy. If this were to crumble, there is likely a low threshold for moving to a cut, given that the option has been opened for a potential downwards move in the cash rate and both economic growth and inflation remains tepid at best. Core inflation hasn’t even met the bottom end of the 2-3% target range singe late 2015, the RBA is an inflation targeting central bank so as soon there is evidence of labour market softness the hurdle to cut will be low. In our view, the RBA will move to cut the cash rate in the second half of this year, but so long as unemployment is trending lower, the RBA will not fully capitulate on policy guidance.

There is also the question of the election, scheduled for May 18, which make a rate cut in May controversial during the campaign. There has only ever been one rate cut during an election campaign (circled below) and that was back in 2013 when Kevin Rudd was in office, but this was a month before the election and came off the back of prior rate cuts. 
There is also the question that RBA has not formally adopted an easing bias yet. In 2016 a weak CPI report prompted the RBA to cut the cash rate from 1.75% to 1.5%, but during that time the central bank had a formal easing bias under the stewardship of Governor Stevens.

Looking at the bigger picture, including Governor Lowe’s speech in February and changes to the April policy decision statement, the signals collectively indicate that the policy bias is creeping slowly away from neutral. The confirmation of “noflation” last week has opened the door for the RBA to adopt a formal easing bias in May and signal an upcoming change in monetary policy, its preferred modus operandi, cutting rates in the second half of this year.

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