Reserve Bank of Australia Cuts Core Inflation Forecast to 1-2%

AUSTRALIA-ECONOMY-RATE-BANK-FOREX

The Reserve Bank of Australia in Sydney.

Photographer: Greg Wood/AFP via Getty Images
  • Three-year bond yields slide to record after RBA revisions
  • Central bank concerned at `surprisingly low wage growth'

Australia’s central bank forecast core inflation is unlikely to reach the bottom of its target this year as the developed world’s disinflation quandary spreads Down Under. The currency dropped about 1 percent and three-year bond yields plunged to a record.

The Reserve Bank of Australia predicted underlying inflation of between 1 and 2 percent in 2016, and then within 1.5 percent and 2.5 percent through June 2018, in its quarterly monetary policy statement. Three months ago, the forecast range for this year was 2 to 3 percent -- also its official target. Friday’s revision spurred traders to increase bets of an August rate cut, pricing in a 61 percent chance compared with 42 percent yesterday.

“If after cutting once and factoring in another rate cut, as per market pricing, you are still only getting to the bottom half of your target band by the end of the forecast horizon, that’s giving a clear signal you feel quite concerned about underlying inflation pressures and the outlook,” said James McIntyre, head of economic research at Macquarie Group Ltd.

The Australian dollar dropped to 73.95 U.S. cents as of 4 p.m. in Sydney. Yields on three-year government debt slid as much as 14 basis points to an unprecedented 1.55 percent.

The release of the updated forecasts prompted some economists to bring forward their rate-cut calls and some to switch to an easing. Seventeen of 23 surveyed by Bloomberg predict the RBA will have cut to a new record low of 1.5 percent by August.

“The phenomenon of surprisingly low wage growth for given labor market conditions has been apparent across a number of advanced economies,” the RBA said. “Furthermore, the recent inflation data indicate that the weakness in domestic cost pressures is not only evident in low growth of nominal wages but is more broadly based.”

Australia’s recession-level wage growth -- partly explained by mining workers moving from higher to lower paid jobs -- is likely to persist longer than previously forecast, compressing inflation. Outside consumer prices, Australia’s economy has appeared in good shape: unemployment is at a 2 1/2-year low, business conditions and confidence are strong and the key iron ore price has rebounded almost 40 percent this year.

The weak inflation outlook underscores the challenge facing incoming RBA Governor Philip Lowe, who will succeed Glenn Stevens on Sept. 18. Lowe will be the first governor in more than 40 years who won’t inherit excessive price growth. When Stevens took the helm in the third quarter of 2006, inflation was 4 percent -- and climbed to 5 percent two years later before the global financial crisis pulled it back.

Growth, Jobs

The RBA on Friday left economic growth forecasts at 2.5 percent to 3.5 percent this year and next and said unemployment will remain around the current 5.7 percent. It gave no guidance on the interest-rate outlook after cutting to a record 1.75 percent Tuesday.

Australia’s resource industries have benefited from policy easing in China, where the central bank has held the main rate at a record low since October. While that’s shown signs of gaining traction, with an across-the-board rebound in China’s March data, it has also been accompanied by an increase in debt to 2.5 times the size of the economy and soaring home prices.

The RBA said China’s authorities appear to be prioritizing short-term growth over “deleveraging and achieving growth that is less reliant on investment and heavy industry” in the longer-term. It said the outlook for China is a “key source of uncertainty.” Australia is the developed world’s most China-dependent economy.

“One risk is that the pursuit of the authorities’ near-term growth targets is likely to increase already elevated levels of debt and could potentially delay addressing the problem of excess capacity in the manufacturing and resources sectors,” the RBA said in its Statement on Monetary Policy.

Unhelpful Aussie

The RBA has also faced difficulties with the currency, which appreciated as much as 15 percent since reaching a more-than-six-year low in January, threatening policy makers’ efforts to rebalance the economy toward sectors like tourism and education and away from mining. These industries are among the most sensitive to the exchange rate and services exports had switched to contributing to growth from detracting from it.

The central bank noted a 10 percent appreciation in the Aussie reduces the level of gross domestic product by between 0.5 percent and 1.5 percent “generally within two years.”

Australia’s inflation shock emerged last month when deflation was recorded in the consumer price index for the first time since 2008 and annual core consumer-price growth slowed to the weakest on record. In response, the RBA cut rates by a quarter-point Tuesday, ending a one-year pause.

Assessing Outlook

“The board will continue to assess the outlook and adjust policy as needed to foster sustainable growth in demand and inflation outcomes consistent with the inflation target over time,” the central bank said.

On the positive side, the RBA forecast household consumption would continue at an above-average pace even as wage growth remained weak, implying a further decline in the savings ratio. It also said the terms of trade, or the ratio of export prices to import prices, would be a bit higher in the near-term, though it didn’t expect the rebound in iron ore prices to last.

The RBA is trying to orchestrate an economic transition away from mining investment to other industries, using low rates and a weaker dollar as a tailwind. In some areas this is working: rising house prices have fueled a residential construction boom and conditions for business are above average. Yet there is little sign of an uptick in investment it’s seeking outside the mining industry.

The central bank did say there remains a “substantial” amount of residential construction work in the pipeline, indicating further strong growth in dwelling investment.

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