RBA keeps rates steady but signals it may not remain that way for long

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  • The Reserve Bank of Australia (RBA) kept Australia’s cash rate steady at 1.5% in May, maintaining the period of policy stability that’s been in place since August 2016.
  • Ahead of the decision, markets and economists saw the prospect of a rate cut as a line-ball call.
  • The RBA trimmed its GDP growth forecasts for this year marginally, and expects a slower decline in unemployment. Importantly, however, it still sees inflation returning to its target, albeit not until 2021 at the earliest.
  • The bank adopted an implicit easing bias, indicating that it may cut rates again should labour market conditions not improve further. Without tighter labour market conditions, inflation is unlikely to return to target.
  • Financial markets are certain the RBA will cut rates by August.

The Reserve Bank of Australia (RBA) kept Australia’s cash rate steady at 1.5% in May, maintaining the period of policy stability that’s been in place since August 2016.

However, it may not remain way for long with the bank adopting an implicit easing bias, indicating it may cut interest rates in the months ahead depending on incoming economic data.

“The Board judged that it was appropriate to hold the stance of policy unchanged at this meeting,” RBA governor Philip Lowe said.

“In doing so, it recognised that there was still spare capacity in the economy and that a further improvement in the labour market was likely to be needed for inflation to be consistent with the target.

“Given this assessment, the board will be paying close attention to developments in the labour market at its upcoming meetings.”

Helping to explain why it decided not to ease policy settings on this occasion, the RBA described current labour market conditions as “strong”.

“There has been a significant increase in employment, the vacancy rate remains high and there are reports of skills shortages in some areas,” Lowe said.

“Strong employment growth over the past year or so has led to some pick-up in wages growth, which is a welcome development. Some further lift in wages growth is expected, although this is likely to be a gradual process.”

Importantly, it still sees Australia’s unemployment rate continuing to trend lower, albeit at a glacial pace and slower than it expected three months ago.

“There has been little further progress in reducing unemployment over the past six months,” Lowe said.

“The unemployment rate has been broadly steady at around 5% over this time and is expected to remain around this level over the next year or so, before declining a little to 4.75% in 2021.”

That view is underpinned by an expectation that Australian economic growth will remain reasonable, if not spectacular, in the coming years.

“The central scenario is for the Australian economy to grow by around 2.75% in 2019 and 2020,” Lowe said, citing increased infrastructure investment and stronger activity in the resources sector as factors that should help to support activity levels over this period.

However, Lowe added a caveat — and a large one at that — to that view.

“The main domestic uncertainty continues to be the outlook for household consumption, which is being affected by a protracted period of low income growth and declining housing prices,” he said.

“Some pick-up in growth in household disposable income is expected and this should support consumption.”

So the RBA expects the economy to grow around trend this year and next, helping to keep unemployment and inflation stable over this period, in theory.

Three months ago, the RBA forecast that Australian GDP would grow by 3% this year before moderating to 2.75% in 2020.

The bank has consistently overstated actual economic growth, resulting in a string of downgrades to its previous forecasts.

Despite that track record, its forecast downgrades continue to be modest in scale, allowing it to maintain the view that lower unemployment, stronger economic growth and faster wage growth will help to lift inflation back to within its 2-3% target.

The RBA has been saying that for quite a while now but hasn’t had much success, something Lowe acknowledged in his commentary.

“The inflation data for the March quarter were noticeably lower than expected and suggest subdued inflationary pressures across much of the economy,” he said.

“Lower housing-related costs and a range of policy decisions affecting administered prices both contributed to this outcome.”

Despite both headline and underlying inflation moving further away from the bank’s 2-3% target in the year to March, Lowe maintained the view that prices pressures will increase, eventually.

“Looking forward, inflation is expected to pick up, but to do so only gradually,” Lowe said.

“The central scenario is for underlying inflation to be 1.75% this year, 2% in 2020 and a little higher after that.”

Previously, the RBA saw underlying inflation moving back to within target by the end of next year. If the RBA is correct, and it hasn’t been recently, it will be more than five years since underlying inflation was within its mandated target.

While slower than previously thought, a trend that has become entrenched over the past three years, the view that inflation will increase, thanks to an expected improvement in labour market conditions, explains why the RBA isn’t prepared to cut rates for the moment.

Elsewhere, the bank’s commentary on domestic housing market conditions and the Australian dollar were similar to what was previously communicated in April.

Internationally, the bank also offered a similar assessment, noting that while the outlook for the global economy “remains reasonable”, the “risks are tilted to the downside”.

While the RBA held off on easing policy settings on this occasion, it won’t take much to change that view should the economy continue to fall short of expectations.

The key data releases in the months ahead will be Australia’s Q1 wage price index, the April and May jobs reports, Q2 CPI in late July along with Q1 GDP in early June.

They will likely determine which indicator is providing the best signal on the strength of the Australian economy — GDP or the labour market.

If that question, or tension as the RBA has described it, is resolved by a weakening in labour market conditions, the RBA will need to take action to help support the Australian economy by easing policy settings further.

Financial markets currently put the odds of a 25 basis point rate cut in June at just 20%. However, that extends to over 100% by the time the bank meets in August.

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