The July 27 June quarter consumer price index report should lay the groundwork for a follow up interest rate cut by the Reserve Bank on August 2. But unlike some other economists, I’m less convinced the RBA will continue to cut interest rates much further heading into 2017.
Let’s first start with the inflation result. The biggest economic shock in Australia so far this year was not the Brexit or China’s wobbly economy, but rather the much lower than expected March quarter consumer price index result.
Contrary to expectations, the RBA’s preferred measures of underlying inflation – the weighted median and trimmed mean – barely rose last quarter, with 0.1% and 0.2% quarterly gains respectively. That result in year on year underlying inflation dropping from around an already too low for comfort 2% to 1.5%. The shock result was enough to rouse the RBA from its slumber and immediately cut interest rates at the next policy meeting.
With the overall economy still ticking along reasonably well – the unemployment rate has been broadly steady and surveyed business conditions are holding at above-average levels – the RBA was right when it felt no need to cut interest rates in recent months. Instead, it’s been waiting for the June quarter consumer price result to confirm that inflation is indeed stuck below its cherished 2 to 3 inflation target.
The anecdotal evidence suggest inflation will remain low. The widely watched National Australian Bank business survey reported quite subdued retail pricing conditions in the June quarter, helped by intense price competition among the major grocery chains (thankyou Aldi!). The Australia dollar has also remained firm, which should keep a lid on import prices. And helped by a still high degree of underemployed Australians, wage growth remains muted.
Note an average 0.5% quarterly gain in underlying inflation would keep annual inflation at 1.5% – which should be enough to goad the RBA into another rate cut. But chances are, given the disinflationary forces across the country, annual inflation might drop to only 1.25%.
In a sense, low inflation and RBA rate cuts are really good news for the economy.
As I’ve previously argued, the economy arguably at present does not need a rate cut – given overall growth is close to trend. But low inflation means the economy deserves a rate cut, as we can afford to aspire to something better – such as above-trend growth and chunky declines in the unemployment rate to 5% or less.
Of course, whether we get this growth outcome remains to be seen, as non-mining business investment remains sluggish and the solid upturn in housing construction appears past its peak. We are increasingly reliant on solid consumer spending and growth in service sectors such as health, education and tourism to drive the economy forward. That said, the strength in business conditions – at least as surveyed monthly by the National Australia Bank – suggests economy is handling its challenges well.
With the Federal election over and the risk of a “hung parliament” in the lower house averted, business confidence might get a further kick along in coming months.
Against this background, it’s not hard to envisage the RBA concluding after an August move that it has sufficiently responded to the surprise decline in inflation and can return to a more neutral policy bias. Helping in this regard, moreover, might be more stirring from the US Federal Reserve about the need to raise US interest rates. Indeed, the US economy appears to have bounced back nicely in the June quarter and markets have shrugged off Brexit risks pretty well. With price and wage inflation stirring and the economy close to full employment, there seems little need for the Fed to wait much longer.
That said, if the Fed concludes it can’t risk raising rates and unduly pushing up the US dollar – especially given continued policy easing bias in Europe and Japan – the RBA will be left in a quandary.
If the Fed remains stubbornly on hold and the RBA intimates it has finished cutting rates itself, the end result might be to keep the $A uncomfortably high at US75c or more. Indeed, the $A with a neutral RBA might continue rising back toward US80c.
Effectively, it’s up the Fed to decide is the “currency wars” continue. If they do, the RBA can’t avoid being an active combatant.
