Maxim Monthly Market Insights - May 2016

• The RBA surprised many by cutting rates in May and then surprised most by downgrading its inflation outlook.

• That’s left plenty of forecasters calling for rates of 1% and below in Australia this year. But will rates really fall that low?  
• Probably not if the Australian dollar falls as far as many are now predicting. A rate of 65 cents would be a significant boost to the national and local economies.

 

Why did the RBA cut and what does it mean?

 

I’ve been writing recently that the Australian economy was growing and businesses were reporting solid conditions, confidence was reasonable, and profitability and trading were looking pretty healthy. Likewise, I’ve been saying that there are more Australians in work than ever before and that helps the Australian economy because all those people earning income means consumer spending and confidence should remain strong.

So it would be fair for readers of my monthly note to wonder what the heck is going on with the Reserve Bank and ask why they eased rates against that backdrop.

It’s a fair challenge. And it’s one that around 60% of traders, market economists, and forecasters were asking before the RBA eased rates. That’s around the percentage, based on market pricing and surveys, who thought the RBA would hold fire and leave rates at 2%.

 

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But the game changed with the release of first quarter CPI in late April. Headline inflation fell by 0.2% for the quarter, leaving the annual increase at just 1.3%. Not only was the quarterly decline the largest since the December quarter 2008, it left the annual increase at the lowest level since the June quarter 2012.

Markets had been expecting an increase of 0.2%, leaving the annual increase unchanged at 1.7%. Core CPI, the bit that takes out the volatile stuff like petrol and fruit and vegetable was also lower than expected. That means for the first time in its inflation targeting history this measure of inflation was below the bottom of the RBA’s 2-3% target band.

As a result, the RBA cut rates by 25 basis points to 1.75%. Yet the release of the minutes to this month’s RBA board meeting show clearly the cut was not about growth. The minutes reflect “in coming to their policy decision, members noted that developments over recent months had not led to a material change in the outlook for economic activity or the unemployment rate, but the outlook for inflation had been revised lower”.

That suggests the RBA knew it had little to lose – in terms of a destabilising acceleration in inflation – by cutting rates and as a result took out insurance for the economy against global forces of deflation by deciding to take the risk of let the economy run a little hotter in the current environment. As long as it doesn’t spook consumers that’s a good thing for the economy and Business.

 

1% in Australia – tell him he’s dreaming

 

Before the CPI data was released I didn’t think the RBA would ease rates anytime soon. Readers of this note know I have been pretty positive about the economic outlook over the past few years. It’s a positivity that I think has been correct to hold.

The employment market nationally has been strong, our own employment market in the Hunter has had a solid rebound from the collapse of a couple of years back, and overall business conditions have been reasonable.

But, that’s not to say I haven’t told clients over the last couple of years that I thought rates will ultimately head to 1%, perhaps lower, in Australia. The reason for that is the growth of the services economy which I believe is both a natural stabiliser of growth and a natural handbrake on wages inflation. That in turn then impacts the base rate from which consumers – households – will be willing to increase their spending and consumption without the addition of debt or running down their savings. I’m at risk of getting too economicy here so I’ll stop – but I’m sure you get the picture.

 

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The question is, does the RBA need to cut rates to 1.25% or 1% by the end of the year as JP Morgan, Macquarie Securities, the Commonwealth Bank, and others are now saying? Former RBA governor Ian Macfarlane believes not and made the point forcefully that’s not the case in an AFR interview this week.

Macfarlane also appears to have a message to those who believe the RBA will have to cut deeply in the future (my emphasis):

“The inflation targeting approach says that if inflation forecasts are below target, we should run an easy monetary policy – we already have that. It doesn’t say that each time we receive an inflation statistic showing it is below target, we have to cut interest rates”.

If inflation stays low the RBA is likely to cut again this year. But as Macfarlane says, they aren’t likely to panic. Importantly with this new inflation environment the RBA is now much further away from rate hikes than most people, businesses, and forecasters expected. Even if rates don’t fall heavily they are unlikely to rise until 2018 at the earliest.

 

The falling Aussie dollar is a natural shock absorber for the Australian economy

 

The mining boom ending let a hole in the Australian economy and hurt the local economy of the Hunter more so than most. But with a diverse economy the Hunter is bouncing back along with Australia. Consumers are spending again, holiday makers are staying home or visiting our region rather than travelling overseas and it’s likely our exporters of manufactures and services are doing better again.  In no small part that will be significantly assisted by the renewed fall of the Australian Dollar which is back at 72 cents – 7.7% lower than the May high. 

The RBA recently said “Since 2013, with the decline in commodity prices and mining investment, and the depreciation of the Australian dollar…Australia’s exports of services, including education, tourism and business services, have increased… while service imports to Australia have declined noticeably”.   A lower dollar is good for the economy.  

 

Tying it all together: There remains little chance of a recession in Australia anytime soon. But low wages growth and the forces of global deflation mean that a theme I have been talking about for years – slow but steady growth – looks like it is becoming entrenched. As long as consumers and business calibrate for this future they will continue to enjoy the benefits of a relatively strong economy.

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