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In the wake of the RBA’s decision at its February board meeting to cut the cash rate 25bp to 2.25%, two questions arise. Firstly, how much further will the RBA cut the cash rate and, when will the RBA cut again. Our view is that the RBA will cut the cash rate another 25bp to 2.00% at its early March meeting and will then take a pause to allow the significant cut in borrowing interest rates over February and March to help boost domestic spending. If the economic outlook it show more promise than in the RBA’s latest set of forecasts issued last Friday, 2.00% may prove to be the base for the cash rate extending into early 2016. There is a risk, however, that Australian economic growth and inflation will track weaker than forecast by the RBA through mid and late 2015, in which case, another set of two 25bp cash rate cuts to 1.50% may be needed late in 2015.
In looking at the RBA’s forecasts released last Friday we see the following:
At face value, the RBA reduced its GDP growth and inflation forecasts only slightly in its February 2015 forecasts, relative to those it produced in November 2014. Essentially, the RBA reduced its annual GDP growth rate forecasts a quarter of a percentage point to a low point of 2.25% in June 2015, a range of 2.25% to 3.25% in December 2015, and a 2.75% to 3.75% range in June 2016. On these forecasts, growth runs sub-trend over the next 18 months with unemployment continuing to trend up for much of that period .
The RBA also tweaked lower its annual inflation forecasts by a quarter of a percentage point. Importantly, underlying annual inflation is now forecast by the RBA to be within 2-3% target band throughout the forecast period extending to June 2017. Another important aspect of the RBA’s forecasts are their technical assumptions. The RBA has built in the market view of interest rates with the cash rate down to 1.75% late in 2015. In short, the RBA’s growth and inflation forecasts are a little weaker than they were back in November, even factoring in more cash rate cuts beyond the one announced last week.
Interestingly, some analysts have taken the modest reduction in the RBA’s growth forecasts to imply little need for the RBA to follow up with a further rate cut in March. We beg to differ. The RBA has produced a set of forecasts showing improving, but still far too soft growth in domestic spending, even with housing activity continuing to run very strongly in some regions. Part of the problem with domestic demand is weak confidence among households and businesses in turn driven by very soft income growth. One area of investment spending is the mining sector. It is starting to fall sharply and with some certainty will weigh on growth for at least the next year or two. In these circumstances, confidence and domestic spending need a material boost and we believe a single 25bp cash rate cut is insufficient to do this.
In the past, the RBA has recognised that when the economic outlook changes, a series of interest rate cuts or hikes have more impact than one small change in isolation. Admittedly in the current rate cutting cycle the RBA is also watching developments in the housing market that in parts are showing signs of over-heating. The issues in the housing market however, should not detract from dealing with the problem of excess capacity in the economy overall. As the RBA points out, it is talking with other financial regulators about what non-interest measures may need to be taken to deal with specific issues in housing.
In summary the economy is growing too slowly to absorb excess capacity and looks set to stay in this state for at least the next year. Inflation is low and is unlikely to threaten the top of the RBA’s 2-3% band for at least two years or more. The RBA needs to recalibrate interest rates to provide more accommodation and promptly. A 25bp instalment was delivered last week and another should come in March in our view. Rates will then probably be on hold for six months after that and if more stimulus is needed, a further set of two 25bp rate cuts to 1.50% late in 2015 is a possibility, although we do not see the need just yet.