This chart explains why so many believe the RBA will cut rates

(Photo by Chip Somodevilla / Getty Images)
  • One of the key responsibilities for the RBA is to see Australian inflation average between 2-3% over the medium-term.
  • It hasn’t been very successful recently with underlying inflation remaining below its target for three consecutive years.
  • Financial markets don’s see that changing anytime soon, seeing inflation averaging just 1.49% over the next decade.
  • Markets are fully priced for the RBA to cut rates once this year, with a second cut seen as a coin toss.
  • The RBA says risks for the next move in Australia’s cash rate are now “more evenly balanced” than late last year.

Financial markets are losing faith that the Reserve Bank of Australia (RBA) will be able to lift inflation back to within its 2-3% target.

As seen in the chart below from Fidelity International, Australian inflation is only expected to average 1.49% over the next decade, leaving it a full percentage point below the midpoint of the RBA’s target, if financial markets are right.

Fidelity International

The chart shows Australia’s 10-year breakeven rate, a measure of what markets believe inflation will average over the decade ahead. Right now, it sits at the lowest level since 2000, when records first began.

Anthony Doyle, Investment Specialist at Fidelity, says markets are giving the RBA a clear signal on what it needs to do next: cut rates.

“The market is telling the RBA that unless it cuts interest rates in the immediate future, there is a substantial chance that it will miss meeting the key target of monetary policy,” he said.

That helps explain why financial markets have a full 25 basis point decrease in Australia’s cash rate already priced in by the end of the year, with a second cut, taking the benchmark rate to just 1%, seen as an even money bet.

Economists are also coming round to this view with 20 of 45 forecasters polled by Thomson Reuters earlier this month looking for at least one rate cut before the year is out.

Amidst a slowdown in the economy, fueled by weak household spending and an expected large decline in residential construction over the next two years, there’s growing concern that softness in the economy may become entrenched, posing upside risks to unemployment and downside risks for inflation, hence why so many believe the RBA will need to act to stimulate economic activity.

If not, it may become even harder for the bank to achieve its inflation mandate, currently set at an average level of 2–3% over the medium term.

Sluggish growth and higher unemployment are not usually the ingredients that would normally lead to higher inflationary pressures, at least in the absence of a global or currency shock. Nor is it a desirable combination to help spur on investment and spending, or for those with existing debts.

Australia’s underlying inflation rate — that which strips out volatile price movements and is far more influential on interest rate settings — has undershot the bottom of the RBA’s 2-3% target over the past three years, and is moving further away from the target according to latest data released by the ABS.

As things currently stand, the RBA is putting faith in strong job market conditions to help gradually lower unemployment in the years ahead, an outcome that it expects will help to boost wage pressures and gradually lift inflation back to its target.

As such, with the RBA’s views underpinned by continued strength in hiring, that means upcoming Australia’s labour market data — starting with this week’s February jobs report — will be crucial in determining what the RBA will do next.

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