My call that the RBA would cut rates in May was originally a little speculative — but following the Q1’19 inflation data, and weak credit data, I now think that it’s very solidly grounded in vanilla macro.
First of all, the very low inflation print cannot be dismissed as a once off. If you take the two-quarter average (as i have done in the above chart), trimmed mean CPI is at an all time low of 0.37%q/q. Given that growth is (at best) around trend, and that the unemployment rate has been stable at ~5% for two quarters, there is no reason to expect inflation to accelerate. Due to measurement issues, inflation is always overstated, so CPI at this level probably means that prices are flat — or perhaps falling a little.
So the question is, assuming current policy settings, can the RBA produce a compelling case that inflation will return to target in a policy relevant time period? I don’t think that they can do so — so the policy rate must fall.
Sure, inflation has been too low for some time, but for most of Gov Lowe’s term, there’s been a trade off between the inflation target and financial stability. This was laid out in Gov Lowe’s landmark speech, Inflation and Monetary Policy, on 18 October 2016. In that speech Gov Lowe emphasised the ‘third pillar’ of the RBA Act, ‘the economic prosperity and welfare of the people of Australia’. The point he made was that rushing the return to 2.5% inflation could have deleterious consequences for the state of household balance sheets.
Over recent times, we have considered the impact of our decisions not only on the future path of inflation, but also on the health of the balance sheets in the economy. Achieving the quickest return of inflation back to 2½ per cent would be unlikely to be in the public interest if it came at the cost of a weakening of balance sheets and an unsustainable build-up of leverage in response to historically low interest rates.Gov Lowe, Inflation and Monetary Policy, Oct 2016
Does anyone think that’s still a barrier to rate cuts? The chart below shows the total value of new finance agreements (to households and firms, 3mma). As you can see, this has fallen sharply of late, and is now at the lowest level in 5 years (since 2014). If you adjust for the larger population / size of the economy this looks even weaker.
The RBA were already considering lower rates following a string of weak growth data — but were reluctant to cut until the famously noisy GDP data was confirmed by rising unemployment. Some argue that the RBA needs to see rising unemployment to cut — but i don’t think that test is relevant any longer.
The low CPI print totally changed the debate. Inflation is too low and the RBA needs above trend growth and a falling unemployment rate to make a case that inflation will accelerate. They don’t have a plausible story about a return to on-target inflation just now. On current policy settings, and assuming a healthy dose of optimism, I can’t see a plausible above trend GDP forecast until mid 2020 — which means inflation doesn’t get back above 2% until 2021.
When will it get back to 2.5%? Who knows. On current form you’d have to guess it’ll be after Gov Lowe’s term ends. Cutting the cash rate is the only way Lowe can have a chance of hitting his inflation target during his term. With a bit of bad luck he might even average something with a 1-handle.
A final point about politics: I don’t think the RBA will be constrained by the 18 May election. I doubt they will even discuss it. Therefore i find it curious that so many are calling a June or July cut. Such a move would look political itself. It would have to be very carefully managed.