The decline of the unemployment rate to 4.9% in February caused the market to substantially reduce the implied probability of a rate cut in May. This is understandable, but i think it’s wrong.
What’s wrong with this is that the unemployment rate is a lagging indicator. Monetary policy works with a lag, so a central bank must be forward looking. Because growth leads employment, being forward looking basically boils down to responding to changes in the growth outlook.
The growth outlook has changed a lot since the February SOMP. Q4’18 GDP printed at ~2.3%, or about 50bps below the RBA’s Feb SOMP forecast. Assuming that Q1’19 is around the same as the average of Q3 and Q4 2018 (the partial data suggests that it’s worse) the pace of growth will slow to ~1.5%yoy in H1’19, or about 100bps below the RBA’s February forecast.
Given potential growth of ~2.75%y/y, GDP growth of ~1.5%y/y should deliver a ~50bps increase of the unemployment rate by the end of 2019.
With the unemployment rate rising, i don’t see how the staff could forecast an accelerating rate of inflation. Increasing slack is typically associated with a decelerating pace of inflation. At best it’ll be stable at ~1.75%
Given the size of the GDP slowdown (that is pretty much baked in by the base effects) the staff are very likely to forecast rising unemployment and slowing inflation.
The question is if Gov Lowe will be forward looking and will respond to the forecast downgrade — or if he needs to see a higher unemployment rate and a still-slower pace of inflation to act.
When he last spoke to Parliament, Gov Lowe said that he would be concerned about inflation spending too long below 2% as it might depress inflation expectations. In the month since he spoke, that is exactly what has happened.
Inflation expectations have collapsed. The market thinks that the RBA doesn’t care about low inflation — and as a result market based measures of inflation expectations have fallen by ~70bps since mid’18 & ~15bps since mid-Feb (here i’m using the RBA’s 10yr bond and indexed yield from the capital market yields tables).
I think the market’s wrong. I think that Gov Lowe does care about his inflation target and that he will respond to slower growth and plunging inflation expectations by lowering the cash rate.
The obvious time to do it is at their 7 May meeting — in response to a slower growth forecast, a higher unemployment rate forecast, and a lower inflation forecast in the SOMP.