RBA holds 3% in Feb — March cut is a 60% chance

As was widely expected, the RBA held their target for the overnight cash rate steady at 3% today.

It appears to have been a closer run thing than the market was expecting, with a significant change in tone causing the foreign exchange value of the AUD to fall, and interest rate futures to rally.

The change? A somewhat  confusing, but (I thought) predictable change in tone — the RBA made their easing bias clear in the conclusion of their statement:

The inflation outlook, as assessed at present, would afford scope to ease policy further, should that be necessary to support demand.

This obviously appears to be a more dovish bias than that which they left us with in December 2012, but I think that’s a wrong conclusion.

As I noted at the time of the December statement, the RBA typically gives less forward guidance in December, so the move back to a more explicit easing bias in February, following the holiday break, normally does not have any particular significance.

There is one place where it does have some significance, however — in weighing their satisfaction with their December rate cut. The adoption of an explicit easing bias in Feb suggests that the Board is very comfortable with their move to 3% in December 2012. This will hopefully silence the chorus that keeps claiming that the 25bps cut to 3% in December was a close call (oddly, the chorus is mostly made up of those who said the RBA would cut to 3% in November, and then said the RBA would not cut to 3% in December).

There are six parts to an RBA statement, let’s deal with them in turn:

Global Growth: an upgrade, as downside risks had ebbed.

Commodity Prices: an upgrade — though the RBA appears to have done the minimum here (AUD commodity export prices are up ~6% from the Dec meeting). Presumably they want to keep their narrative trained on the end of the mining investment boom.

Financial Markets: an upgrade, reflecting the Jan equity market rally and well-functioning capital markets more generally. The RBA struck a skeptical tone here, noting that the de-leveraging task is far from complete (it will take a generation), and that setbacks ought to be expected.

Domestic Demand: unchanged. Around trend over-all, due to resources investment. Scope for further strengthening of non-resources demand as resources investment slows (they can try and make sure this occurs with further rate cuts).

Inflation: downgrade. A 25bps downgrade to core CPI to 2.25%y/y with headline CPI no longer expected to go above 3%y/y. The RBA also dumped the bit about needing better productivity growth to keep inflation low — they now think they are getting it, and judge that they will continue to do so.

Financial Conditions: fingers crossed. There was a lot of new stuff explaining how prior easing is working through the usual channels. The increase in asset prices is the clearest and most uncontroversial sign; the assessment that residential investment is picking up seems more based on hope than fact to me.  There are supportive changes in durables consumption and on the asset allocation side by savers (I see the same signs).

these lead to The Assessment.

The Assessment: With three upgrades and only one downgrade (even if those upgrades are tiny, and the downgrade is major) it seems natural that the RBA left their policy rate unchanged at 3% — but this leaves a few little puzzles, which had to be resolved with the easing bias.

Firstly, inflation is what they do, and excluding the policy and supply shocks, core inflation is running at 2% while demand growth is at best only around trend.  Indeed, non mining demand is probably more important for inflation, and that this is clearly sub-trend.  You typically need above trend growth to get inflation back to 2.5% — so surely you have to ease?

I don’t think they are awaiting more inflation data … that’s an easy judgement, as they clearly say that they are looking at the demand data. That’s why they put in the bit at the end about having scope to ease rates if demand flags.

I think the faster demand is required to keep inflation from remaining sub-target. So i think they need to cut: not if mining sector slips, or if the non-mining sector starts to slow once again.  The RBA will need to cut rates to get core inflation to go back to 2.5%. The RBA thinks that they’ll only need to cut if demand flags — i guess the next two quarters of inflation data will settle our disagreement (by which time they are likely to have cut due to weak demand in any case …)

So the RBA (and we) we await the demand data — to sharpen our guesses about future inflation, and the next move for policy. My current guess is that March is a 60% chance for a cut (warning the probability is subject to heavy revision as more hard data is released).

The fun thing about demand data is that we get some pretty much every week (not that the RBA would ever make a decision based on a single month’s data).  We already have a few bits of data for January, and  what we have suggests that the economy lost pace in January:

1/ Job ads continue to fall: now lower than the GFC low. The ANZ job ads data shows similar.

2/ Australian Manufacturing at 3.5yr low. The Aussie PMI is the lowest in the world at ~40 (50 is trend). Capacity utilization fell 2pts in a month; new orders fell 6pts to ~39pts.

3/ The Services sector is still contracting, though at a slower pace — the PSI is ~45, and new orders fell 1pt to a dismal 43.

4/ Jan Commodity prices up again (following a strong December)