Australian Rate Cuts Back on Table as Disinflation Risk Emerges

  • Headline CPI in deflation, annual core inflation at record low
  • Currency dropped 2% Wednesday as RBA rate-cut odds increased

Australia could resume cutting interest rates following a one-year hiatus as the threat of persistent weak inflation that’s engulfed developed-world counterparts shows signs of emerging Down Under.

The weakest annual consumer-price gain in the domestic economy in 17 years, seen in the non-tradables sector which isn’t prone to one-off swings, suggests the Reserve Bank of Australia will struggle to return inflation to target quickly. Government data Wednesday showed the lowest core inflation reading on record in the first three months of the year.

The reading “is a game changer for the RBA,” said Sally Auld, a Sydney-based interest-rate strategist at JPMorgan Chase & Co. who now expects a cut at the RBA’s Tuesday meeting and again in August, having previously predicted no change. “Off this base, the inflation trajectory will stay weak for the remainder of the year.”

The local dollar dropped more than 2 percent on Wednesday and traders boosted bets on a May rate cut, reflecting the central bank’s penchant for adjusting policy at meetings immediately following the inflation release. Prior to the report, with unemployment at a 2 1/2-year low and business conditions and confidence strong, the prospects of the RBA acting on its easing bias in the near term appeared remote.

Indeed, the central bank had been enjoying success at rebalancing the economy toward industries like tourism and education and away from mining through a record-low 2 percent cash rate and a depreciating currency. Australia’s services exports have shifted from detracting half a percent from gross domestic product to contributing that amount.

Currency Comeback

The RBA was hampered somewhat this year when the currency began retracing earlier losses, climbing more than 5 percent in the first quarter in response to stronger commodity prices and doubts about the pace of the Federal Reserve’s tightening. The U.S. central bank on Wednesday opted not to increase its benchmark rate for a third-straight meeting, although policy makers suggested they remain positive about the underpinnings of U.S. growth.

Challenging Report

For Australia, the latest inflation report is a challenge. It showed tradable goods, which are affected by the currency and other international factors, rose 0.6 percent in the first quarter from a year earlier. Non-tradable goods, which are impacted by domestic variables, climbed 1.7 percent over the period, the weakest result since the second quarter of 1999.

Utilities, a non-tradable, rose just 0.5 percent from the fourth quarter, compared with an average first-quarter increase of 1.6 percent over the past two decades, according to James McIntyre, head of economic research at Macquarie Group Ltd. in Sydney. 

“Disinflation continued across the broad services space,” said McIntyre, who reinstated his rate-cut call for May following the data. “From an inflation expectations perspective, a negative headline outcome will be a concern for the RBA. Particularly when combined with the ‘complication’ for the economy’s transition posed by a higher Australian dollar.”

Australia is showing signs of an affliction the global economy has struggled with in recent times -- generating inflation. Even in economies like the U.S. at or near full employment, workers aren’t pursuing the wage demands that would historically be expected at such times. Similarly, wage growth in Australia is at levels previously seen in its last recession 25 years ago, although the RBA also says this restraint has aided hiring.

Meanwhile, the International Monetary Fund downgraded global growth recently, while concerns about China’s ability to manage financial-market volatility and a vast economic transition to consumption remain. Australia, as a small, open economy and the developed world’s most dependent on China, is particularly vulnerable.

Budget Clash

Yet another complication for the central bank is that the government has brought forward its budget to Tuesday, meaning the policy decision comes on the same day as the year’s key fiscal release. Against that, an election is expected to be called after the budget for early July -- meaning if the RBA wants to move, it should probably do so promptly.

Interbank cash-rate futures on Thursday indicated a 52 percent chance of a quarter-point rate cut in May, up from 14 percent the day before the CPI report. The Australian currency traded at 75.96 U.S. cents as of 8 a.m. in Sydney, down from a 10-month high of 78.35 a week ago.

Su-Lin Ong, head of Australian economic and fixed-income strategy at Royal Bank of Canada in Sydney, believes the central bank will hold off because of the stronger data earlier in the year.

“The hurdle to cut further remains high given the RBA’s reluctance, and a number of factors need to line up,” she said. “The case has strengthened following today’s data but the RBA is likely to want to see some further moderation in employment, housing, and confidence before easing again.”

Before it's here, it's on the Bloomberg Terminal. LEARN MORE