Inflation remains benign according to the Q1 CPI which at 0.4% q-o-q, 2.5% y-o-y came in lower than the market and probably the RBA too were expecting. Importantly, the main two underlying inflation readings were low as well with the trimmed mean up 0.3% q-o-q, 2.2% y-o-y and the weighted median up 0.5% q-o-q, 2.6% y-o-y. On the back of the low inflation readings, the market has started to factor in the possibility of a further cut to the RBA’s cash rate.

Over the past few months the statements accompanying the RBA’s policy decisions keeping the cash rate steady at 3.00% have invariably carried the following sentence. “The inflation outlook, as assessed at present, would afford scope to ease further, should that be necessary to support demand”. Our view remains that the areas of domestic demand most likely to be influenced positively by lower interest rates – housing activity and retail spending – are already rising and even lower interest rates may risk turning sustainable growth in spending into an unsustainable boom in spending.

Apart from the risk of promoting too strong household spending, a second reason why we believe the low Q1 CPI provides insufficient reason for the RBA to cut the cash rate further is that the prices of the sub-component of the CPI for goods and services where prices are largely determined by domestic price pressures, so called non-tradables (about 60% of the CPI basket), was quite high in Q1 and rose by 1.3% q-o-q, 4.2% y-o-y. This high domestically sourced inflation showed in Q1 in components of the CPI such as education,+5.7% q-o-q, +5.8% y-o-y; health, +3.0% y-o-y, +6.1% y-o-y; and housing, +1.2% q-o-q, +5.1% y-o-y.

High domestically sourced inflation has been tempered by falling prices for goods and services where prices are largely determined on the world market, so called tradables(40% of the CPI). Tradables inflation fell by 1.2% q-o-q, 0.2% y-o-y. Much of the deflation in tradables is due to the strong Australian dollar weighing down the price of imports. The greatest deflation in this group in Q1 was in clothing and footwear,-3.9% q-o-q, -1.5% y-o-y and furnishings and household equipment, -1.3% q-o-q, +0.6% y-o-y.

Low inflation based on what is happening in economies overseas and on the strong Australian dollar does not look like sustainably low inflation to us. Rather, if the topping out of the resources investment boom leads to a somewhat lower Australian dollar, the risk is that the CPI eventually migrates nearer to current comparatively high non-tradables inflation unless the RBA remains in its word “prudent” setting the cash rate.

We see the RBA resisting calls for further rate cuts leaving the cash rate on hold at the current record low 3.00%, probably for many months but retaining an easing bias in its monthly statements for a few more months at least. It is worth keeping in mind that the current 3.00% cash rate is influencing banks to keep their lending interest rates around 150 basis points below their long-term average. In this sense, the monetary policy setting is already very easy.

Over the next fortnight or so several key March reports will be released including home building approvals, retail sales and housing finance. We expect all three reports to be relatively strong adding to evidence for January and February that spending is already responding to low rates and needs no further support.