The answer is 50bps (to the RBA’s May question)

The debate surrounding the probable size of the rate cut at the RBA’s May meeting has become a little weird. Well qualified economists are saying things that sound more like pop-psychology than economics.

Economists, in general, make terrible psychologists. Thus, I do not rate (at all) the argument that the RBA will not cut 50bps as it might hurt consumer confidence. I am quite sure my Mum is not going to call me asking if she should be worried on Tuesday afternoon if the Bank eases by 50bps …

I am certain the RBA will discuss a 50bps rate cut at their 1 May meeting, and I judge that a 50bps cut is more likely than a 25bps cut. The main reason – the RBA needs to cut by more than 25bps just to get easy.

Reading the RBA’s April statement and minutes, it seems clear that the RBA’s April meeting ended with agreement that the economy had been weaker than they expected. Following on from this, the board seems to have agreed that weaker growth meant that the output gap was most probably a bit wider and that the medium term inflation outlook was likely to be a bit lower than they had previously judged.

Given the ongoing productivity puzzle, there was uncertainty about this last part (the medium term inflation outlook) and therefore the board wanted to see Q1 CPI to help judge the extent to which slower growth was likely to mean weaker inflation.

With Q1 CPI in hand, the Board not only has the most up-to-date read on the pace of inflation, but also more information about the supply-side of the economy. Both will have helped them firm up their assessment of the medium term inflation outlook.

My guess is that the inflation print will have challenged the RBA staff. Inflation is not just weaker than expected – it’s too low. There has been no inflation for two quarters. The weak supply side story we have all been telling now seems to be fatally damaged.

The new information makes it fairly clear that inflation has been running at ~2.25%y/y pace, on average, for the last two years. The higher readings in H1’11 appear to have been supply-shock related, and at least some of the recent weak readings appear to be the unwind of that supply-shock.

Some have said that the RBA will look through it as it’s ‘just food’ – but that’s not the case. If you look at the ex food and fuel, and ex volatile measures, they tell broadly the same story (note: I seasonally adjusted these measures at the aggregate level to make them comparable with the WM and TM measures, which is fudging bit).

In my judgement, the risk is that the underlying inflation pulse is actually a little lower than 2.25%y/y. The average over the prior two quarters is ~2%y/y pace, and with the economy sub-trend, and the output gap widening, inflation seems more likely to slow further than accelerate. Look at the down-trend in the ‘four core’ average, shown above – there’s something going on.

With inflation running at least 25bps below prior RBA expectations, and decelerating, the RBA needs to ease policy by 25bps, just to get the real cash rate down to the level they had previously thought they were at. That is, they must lower their rate by at least 25bps due to the inflation under-shoot, just to ease back to where they figured they were a few months back.

To this, we must add the cut they signalled in April to do due to the growth undershoot (so long as inflation was moderate). For mine, this means (at least) two cuts. If you know you want to be 50bps easier, what’s the wait?

In any case, if you want to get 50bps through to borrowers, you are probably going to have to cut by 75bps – as the Banks will soak up ~20% of any easing.

Zooming out for a moment, the most likely explanation for the recent growth-inflation performance is that monetary policy has been tight. I suspect that the neutral RBA policy rate is modestly lower than the present rate — say ~4%, or perhaps a bit lower. So if the RBA wants to be ‘stimulatory’ they are going to have to cut by more than 25bps.

Other factors suggest to me that the RBA has more than 50bps of easing to do. With the UK back in recession, Euro Business indices turning down once again, and US data also slowing, their global growth outlook probably needs to be revised lower. Similarly, financing markets have become a little more difficult, in recent months.