Australia’s crucial June quarter consumer price inflation (CPI) report is just a day away from being released.
It will be massive event, and likely bring extreme market volatility, especially if the core inflation reading comes in higher than the 0.4% level expected by economists.
The markets are waiting, as are the Reserve Bank of Australia, to see whether the core inflation print will be low enough to warrant another rate cut, as was the case when the previous CPI report was released in late April.
While that question, and whether the RBA will likely need to cut again, will be answered in a little over 24 hours, the Commonwealth Bank’s fixed income and rates research team, led by Adam Donaldson, believe that the same underlying factors that led to the extremely low March quarter core CPI print were prevalent again in Q2.
The issue, as we see it, is that the background factors driving inflation so low in Q1 (+0.15% average of the two RBA core measures) remain in place. The AUD strengthened slightly on a trade-weighted basis in Q2, doing nothing to change the deflationary picture spilling to Australia’s shores from the rest of the world. The income squeeze from soft commodity prices thus continues to feed through to households, where wage outcomes remained weak and the evidence suggests underemployment stepped up notwithstanding superficially adequate jobs reports through the quarter. Disruptive technology and globalisation act to ensure that squeeze filters through to a very tough retail and broader consumer pricing environment that suggests disinflation will mount as the support from the previous sharp drop in the AUD continues to fade into the background.
Should those factors lead to another ultra-benign core inflation reading in Q2, the CBA suggest it could negatively impact the outlook for wages and household spending, making it more difficult for the RBA to bring inflation back to within its 2-3% medium-term target.
The risk we see is that the inflation data proves weak enough to put the RBA on the spot and call into question prior forecasts for inflation to return toward the target band. Australian market inflation expectations have dropped materially this year even as US break-evens have lifted slightly. Another low CPI outcome could see that spread to other sectors of the economy, where expectations have so far remained more stable, generating greater concern over the outlook for wages and household spending.
Should such a scenario eventuate, the CBA believes it “could bring on the need for the RBA to rapidly adopt a more aggressive stance”.
Further rate cuts, in other words, and more frequently — something that the vast majority in financial markets do not envisage beyond the likely reduction in the cash rate expected when the RBA meets on August 2.
While such an outcome may seem fanciful to some, the CBA’s rates team was on the money when it came to calling the interest rate reduction that occurred in May, forecasting the move well in advance of the market and before the release of the Q1 CPI report.
Currently economists at the CBA have the RBA cutting interest rates to 1.25% by the end of 2016, putting them at odds with Australia’s other big four bank’s who are predicting one rate cut, or in the case of the National Australia Bank, none, before the year is out.
According to the latest survey of economists conducted by Bloomberg, all bar one bank — the NAB — see the RBA cutting the official cash rate to 1.5% at its August 2 meeting.
Looking further ahead, the likes of AMP Capital, JP Morgan, Morgan Stanley and Nomura Australia join the CBA by predicting that the cash rate will fall to 1.25% by the end of the first quarter of 2017.
Cash rate futures trading on the Australian Securities Exchange (ASX) currently put the odds of a 25 basis point reduction in Australia’s cash rate in August, taking it to 1.5%, at a two-in-three chance.
By November, markets currently price a slim chance that the cash rate will be reduced again to 1.25%.
All of those expectations will likely change when the Q2 CPI report is released at 11.30am AEST on Wednesday, one way or the other.
Markets expect a quarterly core inflation reading of 0.4%, something that will leave the year-on-year rate at 1.4%, something that will mark the lowest level on record should it eventuate.
In May, the RBA forecast that the low point for core inflation would be 1.5% in Q2. Beyond that, it forecast that the rate would gradually move back to the low-end of its 2-3% inflation target by mid-2018.
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