RBA takes a step toward easing

In their October statement the RBA downgraded their domestic and global growth forecasts, and as a result their inflation forecast also appears to have come down somewhat. Just how far the inflation forecast has fallen, the Bank has yet to say – they indicate that this forecast will be finalised prior to their next meeting (they are awaiting the release of the Q3 CPI report in late October).

I have spent a bit of time modelling Australian Inflation, and my guess is that their CPI forecast is now inside their 2–3 per cent target range over the next year, and probably over their forecast horizon. My own forecast is that inflation will probably peak a little below 3%yoy late this year, and then fall back to ~2.75%yoy thereafter.

That’s not low enough for the RBA to cut rates – they’d need to forecast inflation at or below 2.5%.

So could their ‘right tail’ forecast (the bit at the end, when policy has had its full impact) fall from 3.25% in August to 2.5% in November?

Unlikely, but possible — but getting there actually has little to do with the Q3 CPI report.

What you need to see to get the RBA’s inflation forecast to 2.5% or below is a further increase in the rate of unemployment, and a further decline in market measures of break-even inflation. These latter two are much more important for a medium term inflation forecast.

If we get a low Q3 CPI report at the end of this month, and the unemployment rate heads up to 5.5% in the October labour market report (which covers the month of September), and market measures of inflation expectations continue to decline, their inflation forecast may get low enough for the RBA to begin a rate cutting cycle at their November meeting. If so, i think that it’ll just be a 25bps cut – most probably followed by another in December, and perhaps two more in 2012 … to take cash down to 3.75%.

Of course, even if none of these things happen, a cut is possible if Greece defaults, or if some other calamity befalls the global financial system. In that case, expect 50bps or 100bps cuts.

What about the boost from the weakness of the AUD?

I’ve always thought that for the AUD (and other ‘risk-on’ pairs) the strength or weakness of the currency embodies a lot of information about the economy’s economic prospects … so a weak currency is seldom an impediment to the easing of interest rate policy.

Personally, I doubt that the RBA will get the evidence they need to lower their inflation forecast by a whopping 75bps in a single quarter (between their August and November SOMPs). Thus, I think the earliest likely quarter for a rate cut is Q1’12. With the Bank having stalled longer, it’s more likely to be a 50bps move – with the end point likely to be 3.75% in Q3’12.