How low will the RBA go?

Tomorrow it is almost certain that the Reserve Bank of Australia will move to cut the official cash rate for the first time since August 2016, from 1.5% to a new record low of 1.25%. The RBA will finally succumb to the realities of the slowing economy with pervasive weak inflationary pressures and where stagnant wage growth and a deteriorating labour market is placing downward pressure on consumption. It's an ugly cocktail for an economy so heavily reliant on private consumption. 

According to the futures market, the probability that the RBA will move to cut the cash rate to 1.25% is sitting at 100%. In a speech delivered to the Economic Society of Australia in Brisbane two weeks ago, RBA Governor Philip Lowe gave a clear signal that rate cuts are coming, saying “at our meeting in two weeks' time, we will consider the case for lower interest rates.” Unless there has been a serious communication mishap, it is a given that the RBA will move tomorrow.

With the move lower in the cash rate being a given, the question then becomes how low will the RBA go? Given that the forecasts in the May Statement on Monetary Policy were predicated on two rate cuts, 50 basis points by year-end should be an inevitability. However, it is hard to see just two rate cuts providing a material impact in returning inflation to target. Again Governor Lowe’s speech (as opposed to the statement accompanying the cash rate decision) could be vital in deciphering when the RBA will follow up with a second, 25 bps rate cut.

A move beyond 50 bps will likely be dependent on the fiscal response from the government. This is a point the RBA has been at pains to highlight, calling upon the government to increase spending.

“In the event that the unemployment rate does not move lower with current policy settings, there are a number of options. These include: further monetary easing; additional fiscal support, including through spending on infrastructure; and structural policies that support firms expanding, investing and employing people. Relying on just one type of policy has limitations, so each of these is worth thinking about.”

This plea from the RBA is not just demonstrating the impotence of monetary policy fast approaching the zero-lower bound, but a wake-up call to the Morrison government. A coordinated response and focus on productivity reforms, infrastructure spending and other fiscal measures will be necessary to reignite confidence and a self-sustaining recovery in economic growth.   

In April, we saw that the unemployment rate has now increased to 5.2%, up from an eight-year low of 4.9% in February. Given that the RBA has abandoned other indicators of economic health to explicitly tie the outlook for monetary policy to the labour market, continued deterioration would point to further cuts to come. 

Spare capacity picked up in April; this is an ongoing issue for the RBA preventing material upward pressure on wages. Several leading indicators are also pointing to a slowdown in hiring, meaning unemployment has the potential to further increase. Just today, ANZ job ads continue to paint a worrying trend, recording the largest monthly drop since the financial crisis. The run-up to the election and the Anzac/Easter public holidays likely contributed to the severity of this decline, but the overall trend remains intact and confirms weakness seen in other leading indicators like the NAB business survey employment index, and capacity utilisation.