Kay Van-Petersen
Australia’s Q3 CPI figures proved positive, says Saxo Capital Markets’ global macro strategy Kay Van-Petersen, but the banks didn’t appear to be buying it.
Article / 20 July 2016 at 1:55 GMT

RBA may move goalposts on inflation target

Managing Director / Technical Research Limited
New Zealand
  • Market firms on August AUD rate cut after release of RBA minutes
  • CPI figures next Wednesday will be critical to the Bank's decision
  • Inflation targets may need a rethink in current global climate

By Max McKegg

The Australian dollar has been the biggest loser over the last 24 hours as markets settle on the idea that the Reserve Bank of Australia will cut its 1.75% policy rate by 25 basis points when it meets on August 2. 

Money market pricing suggests the chances have now risen to 60%, the catalyst being publication yesterday of the minutes from the bank’s previous meeting on July 5. However, the minutes weren’t definitive and neither the RBA nor the markets will be able to make a final call until we see the June quarter inflation update next Wednesday.

The Australian economy doesn’t need a rate cut. GDP is expanding around 3% per annum, slightly above potential, the unemployment rate is close to its natural level, exports are buoyant and the housing market is booming. The problem is none of this is feeding through into inflation and, like so many other central banks, the RBA is locked into an inflation-targeting straight-jacket, self-imposed in the 1990s and recently re-affirmed.

The RBA's inflation goal of 2%-3% is a target that even football ace Cristiano Ronaldo
would likely miss. Photo: iStock

In the Statement of the Conduct of Monetary Policy signed in Oct 2013 “both the Reserve Bank and the Government agree on the objective of keeping consumer price inflation between 2% and 3%, on average, over the cycle. This formulation allows for the natural short-run variation in inflation over the cycle while preserving a clearly identifiable performance benchmark over time”.

That’s a narrow goal to be aiming at, one that even football aces Cristiano Ronaldo and Lionel Messi would probably miss “on average”. And Reserve Bank of Australia Governor Glenn Stevens is proving he’s no sharp-shooter. As the chart below shows, inflation has fallen below the 2%-3% target zone, whichever way you cut it.

dsds Source: Reserve Bank of Australia
The downtrend is likely to continue next Wednesday when the June quarter Consumer Price Index numbers are released. The RBA doesn’t provide quarterly CPI forecasts but, judging by the projection made in its June Monetary Policy Statement that inflation will average 1.5% over 2016, we can infer they will be looking for a number close to 0.5% for the June quarter. 

Private sector economists are expecting a more modest 0.3%-0.4%, and in today’s environment where one decimal point can make all the difference, that’s likely to be enough to force the Bank’s hand to cut on August 2 with a full explanation for the move to follow in the August 5 Monetary Policy Statement when updated economic forecasts will be published.

Adding weight to the argument in favour of an imminent rate cut is the recent rally in AUDUSD, which will add downward pressure to inflation in coming months. The minutes said “an appreciating exchange rate could complicate the necessary adjustments” the economy still has to make if it is to move away from dependence on the mining industry. 

By “exchange rate” the Bank means the Trade Weighted Index, illustrated in the chart below (Click to enlarge). The dotted lines show the timing of the three 25 basis point rate cuts from 2.50% made so far in this easing cycle. The TWI has risen 4.5% since early June when the RBA’s last set of economic forecasts were published. 


Source: Reserve Bank of Australia

The June forecasts had inflation averaging 1.5% in 2016, assuming “market pricing” for the future direction of interest rates. Market pricing at the time had the 1.75% policy rate down to 1.5% by August. So it can be argued that a cut on August 2 is a done deal because inflation at 1.5% would be under the RBA’s 2%-3% target zone. That would be the case even if next Wednesday’s update matched the Bank’s forecast.

There is some talk the Bank will instead take the opportunity to either widen the target to 1%-3% or extend the period within which the current target will be reached. The justification would be the economy doesn’t need a rate cut and slavish adherence to a narrow inflation target would do more harm than good. Certainly there would be precedents for extending the target achievement date: the Bank of Japan and the European Central Bank do it on a regular basis while the US Federal Reserve was careful not to lock itself into re-timing in the first place.

So it  comes down to a call between delivering a rate cut the economy doesn’t need or moving the goal posts. Tinkering with the current Statement on the Conduct of Monetary Policy would not be done lightly and it’s probable the RBA would first float the idea, perhaps in the Monetary Policy Statement on August 5.

The newly re-elected government of Prime Minister Malcolm Turnbull would also have to be on board.

It’s an intriguing idea for Stevens’ successor as RBA Governor to consider in the future, but in the meantime monetary policy must be consistent with the self-imposed straight-jacket of 2%-3% inflation, a “clearly identifiable benchmark”.  

In such circumstances, it’s to hard to see how a rate cut can be avoided. But with markets still only pricing in a 60% chance of that happening, there is still potential for another downward move in AUDUSD if next week’s CPI release turns a potential cut into a done deal.

– Edited by Caroline Shone

Max McKegg is managing director of Technical Research Limited. If you would like an email notice each time Max posts a trade or article then click here or post your comment below to engage with Saxo Bank's social trading platform.
20 July
ChartFollower ChartFollower
good piece Max


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