GAME-CHANGER: Economists react to Australia’s ‘exceptionally weak’ inflation report

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The weakness of Australia’s March quarter inflation report has stunned financial markets, opening the door to a potential rate cut from the RBA as early as next week.

Headline inflation actually fell — the first time that’s occurred since the December quarter 2008 — printing at -0.2%, below even the lowest forecast offered in a survey of 25 economists polled by Bloomberg.

At 1.3%, annual inflation is now running at the equal lowest level seen since the June quarter of 2012.

More importantly, given its influence over the outlook for Australian interest rates, core inflation rose by just 0.15% over the quarter.

It’s well below the 0.5% increase expected, and left the annual rate at 1.55%, the lowest level since the series first began in 1983.

After sitting at the bottom of the RBA’s 2-3% target band in recent quarters, the core reading is now almost 0.5% below.

That number changed the discussion on the outlook for Australian interest rates. A rate cut in May — deemed laughable by some before today’s release — is now priced as more likely than not by interest rate traders.

It’s been that influential.

While the markets think it’s more likely than not that RBA will take the cash rate to 1.75% next Tuesday, it’s time to see what economists have made of the weak inflation report.

Most continue to express the view that the inflation report — in isolation — will not be enough to see the RBA deliver a rate cut in May, but if there’s one common theme that we’ve seen in research notes received so far, its a series of caveats and disclaimers explaining why that call could be wrong.

Here are their views, starting Commonwealth Bank’s Michael Blythe:

Michael Blythe, CBA

We are reviewing our RBA rate call in light of the lower than expected inflation trends. Clearly the chances of a rate cut next week have moved a lot higher. But today’s numbers may still not “demand” a rate cut.

The RBA has tolerated below target inflation on a number of occasions. It is after all how the inflation targeting regime is supposed to work. The last time we saw inflation rates around the current figures was in 1997-98. Back then there were 6 out of 7 quarters where underlying inflation was below target. For most of that period the RBA left the cash rate at 5%.

Tim Toohey, Goldman Sachs

The RBA clearly established the criteria required for them to act upon their easing bias; weak inflation, slowing employment growth and a currency at a level that challenges the RBA assumptions of future economic growth. On all three criteria the evidence supports the case to ease policy in May.

Should the RBA choose to remain on hold in May they will be more than aware that the calendar quickly becomes crowded by a likely election campaign through May to early July and the leadership transition at the RBA scheduled for September.

History has shown that since 1990 the RBA has not been overly influenced by political and leadership events.

We continue to believe that the course of least regret is for the RBA to follow its inflation targeting framework and ease in May, where we continue to forecast a 25bp reduction. Nevertheless, following the possibility of an early election in July we have decided to move our final forecast rate cut to November 2016.

Justin Smirk, Westpac

Low inflation, on its own, is not a trigger for a rate cut. Sure, it unlocks the interest rate door for the RBA should it decide it needs to walk through that door as the Bank would not have to wait for another CPI update before doing so. However, it does not mean that the RBA will cut rates!

A rate cut is dependent on local economic conditions demanding a rate cut. With unemployment on a new downtrend this is not so at the moment and we suggest that the RBA is waiting to see a new weaker trend in domestic activity and employment before it would embark on such a strategy.

Jo Masters, ANZ

Today’s data puts the RBA in a difficult position. The inflation pulse is weak and it now seems likely that underlying inflation will remain below the policy target band for some time. That said, domestic activity looks solid at the moment, although the RBA would be cognisant that some of the tailwinds are likely to fade in the second half of this year.

Alan Oster, NAB

The weak inflation outcome opens the door to another rate cut and makes the May Board meeting “live”. Nevertheless, recent activity data don’t appear to argue that there is an imminent need to make such a cut. The debate will likely hinge around whether there are risks to the Bank’s inflation targeting credibility and whether the unemployment rate would be lowered more quickly.

In this context we are currently reviewing our rate forecasts.

Paul Dales, Capital Economics

The sharp fall in underlying inflation to 1.5% in the first quarter is a game-changer for the Reserve Bank of Australia and supports our long-held view that interest rates will fall from 2.0% now to 1.5%.

The persistent weakness in economic activity in recent years has dragged underlying inflation well below the RBA’s 2-3% target range. Whereas the RBA was previously thinking that low inflation was a good thing as it would allow it to cut interest rates further if demand faltered, it is now clear that low inflation itself is the problem.

Scott Haslem, UBS

Today’s Q1 CPI was materially lower than expected, with underlying inflation below the RBA’s 2-3% target for only the 2nd time in 15 years

Given 3.0% GDP growth & 5.7% unemployment, we doubt a short period of subtarget core CPI is a sufficient condition alone for the RBA to trim. But it certainly lowers the hurdle for further cuts, should the outlook deteriorate. The RBA will need to lower their near-term CPI targets in next month’s SOMP. The key is how far out they lower them?

Shane Oliver, AMP Capital

Both headline and underlying inflation are now running well below the RBA’s target range of 2 to 3%. While this is not a problem for short periods, the risk is that thanks to a combination of deflationary pressures globally, soft demand domestically and very weak wages growth inflation could remain well below target for an extended period.

This is a risk that the RBA cannot ignore and as a result we remain of the view that the RBA will cut interest rates again in the months ahead. While we had virtually given up on a cut at its May meeting next week after recent solid jobs data, there is now a reasonable chance that it may move next Tuesday.

Paul Bloxham, HSBC

Low inflation partly reflects that the end of the mining investment boom has brought an extended period of below-trend growth, which has weighed on wages and price pressures in the economy. Global inflation has also been very low. More recently, low global inflation and rates have seen the AUD climb, which is set to weigh further on the outlook for inflation and could also weigh on growth.

Weighing all of this up, there is no denying that inflation is too low, which means that the cash rate almost certainly needs to be cut. The usual rule of thumb is the sooner the better. We retain our view that the RBA is likely to cut by 25bp in Q2. We now expect that a cut in May is likely, despite the budget. We now also expect a follow-up 25bp cut in Q3 and for the cash rate to remain at 1.50% over the forecast horizon.