THE BIG PICTURE: Why the RBA’s got room to trim rates

The inflation data has come and gone for another quarter, so it is worth taking a big picture look at the results.

First there was the data on import and export prices. Import prices fell by 1.2% in the March quarter, with all but one of one of the major categories falling over the period. A stronger Australian dollar was a big driver of the declines. Import prices are still 2.1% higher than a year ago but that largely reflects higher fuel prices.

Of particular note was the price index of imported consumer goods, down by 2.7% to 109.9 – the lowest result in 20 years (since June quarter 1992). And export prices also plunged, down by 7.0% in the March quarter. The main drivers of lower export prices were declines in prices for iron ore, gold, coal and gas.

Then there was the data on producer prices, or business inflation, down by 0.3 % in the March quarter – the biggest decline in just over two years. Again a key driver was the stronger Australian dollar as import prices fell by 1.5%. But the decline wasn’t just caused by the firmer Aussie dollar in the quarter but reflected the pass through of currency gains in previous months. And prices of domestically produced goods also fell by 0.1%.

That just left the consumer price index – the main gauge of economy-wide inflation. And there was yet more deflation – falling prices. The seasonally adjusted CPI fell by 0.2% – the biggest price drop in almost 15 years.

The annual rate of inflation slumped to 1.6%. Underlying price measures didn’t actually fall in price, but results were historically low and below market expectations. Underlying inflation (excludes more volatile elements) rose by 0.4% in the quarter and by 2.1% over the year.

The bottom line is that inflationary pressures are contained. The resource boom has pushed up the Aussie dollar and the gains are being spread around in lower prices. Businesses have also been reluctant to raise prices because consumers have been reluctant to spend.

Not only is inflation low now; but weak producer prices also point to inflation remaining low. And all this means that the Reserve Bank can safely trim interest rates.

The week ahead

The spotlight is shone on the Reserve Bank in the coming week. The Reserve Bank Board meets on Tuesday while the quarterly statement on monetary policy is released on Friday. In the US, the highlight is Friday’s non-farm payrolls (employment) report.

On Monday, the monthly inflation gauge is released by TD Securities and the Melbourne Institute while data on private sector credit (lending), new home sales and the RP Data–Rismark Home Value index are also issued.

The monthly inflation gauge is proving to be an accurate early warning indicator on inflation. The March result noted an annual inflation rate of 1.8% and indeed this proved far more accurate that the forecasts made by Australia’s economic literati. Clearly the data will get greater attention by economists and investors alike.

Private sector credit (lending) probably rose by 0.2% in March, reflecting weaker new lending figures, after lifting 0.4% in February. We expect the annual growth rate to ease from 3.5% to 3.1%.

There are tentative signs of a recovery in the housing market with home prices up 0.2% in March. Demand for homes is lifting, underpinned by firmer migration levels, but new supply isn’t lifting markedly. As a result we expect further recovery in home prices over 2012 – especially if the Reserve Bank cuts rates.

And that brings us to the Reserve Bank Board meeting on Tuesday. We believe there is an ironclad case for the Bank to cut rates by at least a quarter of 1%. The economy has been calmed, inflation is under control, future inflation looks set to remain low and there are all manner of global risks.

We believe that the Reserve Bank will only cut rates by 25 basis points, keeping ammunition on hand should further stimulus be required.

The April Performance of Manufacturing Index is also released on Tuesday and given that the latest reading suggested that the sector was contracting, the data is a timely reminder about why a rate cut is warranted.

Also of note, the ABS House Price Index is released on Tuesday and Performance of Services Index on Thursday.

The other major event in the coming week is the quarterly Statement on Monetary Policy – the Reserve Bank’s comprehensive assessment of economic and financial developments. The main interest will be in the latest forecasts of economic growth and inflation. If growth is expected to remain ‘below trend’ and inflation is expected to stay below 3%, then the Reserve Bank would be signalling that it could cut rates further over 2012.

In the US, data on personal income and spending is released on Monday together with regional economic gauges covering Dallas and Chicago. Economists tip healthy gains of 0.3% for incomes and 0.4% for spending during March.

On Tuesday, the ISM manufacturing gauge is released in the US together with car sales and construction spending. And on the same day the equivalent gauge of manufacturing activity – the PMI – is released in other parts of the globe such as Europe and China. In the US the ISM index is tipped near 53.4.

On Wednesday, the ADP National Employment index is released in the US – the precursor to Friday’s official job report. Economists tip a 190,000 lift in private sector jobs in April after the 209,000 increase in March. Data on factory orders is released the same day.

On Thursday, the Challenger job lay-off index is released together with productivity figures and the ISM services gauge. Solid growth is occurring in the US services sector as evidenced by the current reading of 56.0 for the ISM gauge. Economists don’t expect much change in the result in April.

And, on Friday, the non-farm payrolls data for April is released. In March the data disappointed with only 120,000 new jobs created. Economists believe that this was a temporary blip in the recovery process and job growth of around 175,000 is tipped for April. However, the unemployment rate is expected to remain steady at 8.2%.

In China, the official purchasing managers’ index is released on Tuesday with the HSBC variant on Wednesday and then the services sector PMI is issued on Friday.

Sharemarket, interest rates, currencies and commodities

Financial markets have fully priced in a 25 basis point rate cut on Tuesday. In fact, market participants have gone a step further and factored in a 29% chance of an additional 25 basis point rate cut – in essence 32 basis points is priced in.

Looking further out, the cash rate is assumed to fall to 3.43 % in 12 months’ time, suggesting three rate cuts, each of 25 basis points.

Similarly the bank bill futures market has priced in a number of rate cuts over 2012 with the implied yield on 90-day bank bills in December at 3.52%. Currently, physical 90-day bank bills are yielding 4.17 %.

The Aussie dollar certainly lost ground following the release of the March quarter inflation data. So what of our strategists’ view that the Aussie will end the year closer to US109 cents. The strategists point out that China is well positioned to stimulate growth while the outlook for the US economy remains positive and the Federal Reserve has vowed to keep rates low.

It’s important to remember that the Aussie has, on average, fluctuated US6.6 cents between highs and lows each quarter over the past 20 years. The Aussie has lost momentum in recent weeks but factors can change quite quickly.

Craig James is the chief economist at CommSec.


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