Less than a month ago the Australian Bureau of Statistics’ March quarter consumer price inflation (CPI) report reverberated across financial markets, particularly in Australia.
At 1.55%, the annual core inflation figure was the lowest level on record, surprising many in financial markets, including the Reserve Bank of Australia (RBA).
In response to the sharp deceleration in inflationary pressures, the RBA cut interest rates less than a week later, taking its benchmark cash rate to just 1.75%, the lowest level on record.
The bank then followed up by drastically reducing its inflation forecasts for the years ahead, predicting that core CPI was only likely to reach the bottom of its 2-3% inflation target by mid-2018.
Markets and economists reacted, rushing to price in the likelihood that another rate cut was coming, or more, later in the year.
However, just when it looked like another rate cut was a certainty rather than a possibility, the minutes of the RBA’s May monetary policy meeting revealed policymakers had to be “persuaded” to cut interest rates to help bring inflation back into the bank’s target band.
That revelation — suggesting that the decision was far closer than many had imagined — created doubt as to whether another rate cut would be forthcoming.
This view was further strengthened by RBA board member John Edwards, who conveyed a lack of urgency to bring inflation back within target in an interview with the Wall Street Journal on Friday.
“It is certainly right to say that, at this point it is below target,” Edwards told the Journal. “But then it has never been the view that the target had to be achieved each and every quarter, or for that matter each and every couple of quarters, or year for that matter.”
“The target exists, and I think it will be desirable to return over time to the midpoint of the target, but I don’t think it can be done urgently,” he added.
As we wrote at the time, it certainly didn’t sound like a central banker who was pondering whether to deliver back-to-back rate cuts in an attempt to bring inflation back to within target.
Rather than the continued focus on returning inflation to target, Edwards suggested that the anchoring of inflation expectations was more important, acknowledging that it would be critical to the outlook for interest rates.
“(The key question is) are inflation expectations anchored around where they had been, and so far I think they probably still are,” he said.
That was an important admission, indicating that the view of Australian businesses and consumers — you — towards the inflation outlook would be a key factor in determining whether the bank will see the need to reduce rates further.
As suggested by Edwards, Australian inflation expectations are currently anchored, as demonstrated in the chart below, supplied by Tapas Strickland and David de Garis, from the NAB’s economics team.
Private sector economists, union officials or consumers all currently expect inflation will sit in the middle of the RBA’s 2-3% inflation target over the longer-term.
While the expectations are definitely lower than they’ve been in the past, all three remain well above the 1.55% annual inflation rate seen in the March quarter of this year.
Strickland and de Garis, echoing the sentiment from Edwards, suggest that shifts in expectations, whether higher or lower, will likely determine how long the RBA will tolerate below-range inflation without touching interest rates further.
“The length of time that a central bank can “look through” such periods is dependent on whether consumers and businesses factor in below-target inflation into their forward-looking price and wage setting behaviour,” they wrote in a research note released on Monday.
“If consumers did factor low inflation in, what began as a temporary period of low inflation could then become entrenched. On the other hand, if consumers and businesses remained confident that inflation will return to within the target band, then inflation would tend to return to target once one-off effects have abated.
“In other words, the key thing for monetary policy in a period when inflation is below target is are inflation expectations anchored around where they had been?”
To the NAB, one of only a handful of banks not predicting another rate cut this year, inflation expectations would have to shift lower to bring on additional easing.
“If inflationary expectations became de-anchored than real interest rates would rise (real interest rates ≈ nominal interest rates + expected inflation). That could increase real rates above their equilibrium levels and depress future economic growth,” says Strickland and de Garis.
“Though we do acknowledge a further rate cut remains a possibility if inflation continues to surprise to the low side and has the risk of a more entrenched nature, or if activity forecasts are revised lower, we do not expect such a move to be considered before the next CPI release.
“Inflationary expectations remain within the 2-3% band, giving the RBA a degree of comfort to keep policy on hold.”
In a survey of 24 economists polled by Bloomberg, 22 see the RBA reducing the cash rate to 1.50% by August. Financial markets share a similar view, putting the probability of a 0.25% reduction on August 2 at 68%.