“I have been asking myself what can we do that will be most conducive to supporting confidence, predictability, the sense that people can make some plans for their business, their own life, whatever it might be, and the view I came to pretty early on was: what we should be doing is giving a message of stability and predictability insofar as we can”. Those were the words from RBA Governor Glenn Stevens in an interview with the Australian Financial Review on December 12 last year. His view, at least back then, was that the best way to help spur ‘animal spirits’, create confidence amongst Australian businesses and households to undertake investment decisions, was to offer a sense of stability and certainty when it came to interest rates. Before the interview financial markets had gradually been pricing in the likelihood that the RBA would be ease monetary policy further in 2015. Many, like ourselves, saw the article as an attempt to correct market pricing. Rate cuts, despite the obvious benefits to many business and household balance sheets, could actually hurt business and household confidence due to concerns over the health of the domestic and international economies. Now, only seven weeks later, those views have been widely dismissed. A February rate cut, the first of a series this year, is now seen as likely.
Markets have reacted accordingly. The Australian Dollar, already under pressure due to heightened expectations that the US Federal Reserve will begin to tighten policy midway through the year, has weakened. The ASX 200, led by substantial gains in higher-yielding sectors, has rallied hard in anticipation of a lower interest rate environment ahead. Debt markets, whether for short, medium or longer-term durations, have also strengthened significantly. So what changed in just seven short weeks to see rate expectations swing so dramatically from one view to another?
The first, and perhaps most influential factor, has been the slide in global inflation expectations. Disinflationary pressures have accelerated in the US, China, Japan and UK. In the Eurozone it’s been outright deflation. The response of central banks globally, particularly in developed nations, has been stark. The European Central Bank has enacted outright quantitative easing. Canada, Denmark, Sweden and Norway have all cut interest rates unexpectedly. The Reserve Bank of New Zealand has dropped its tightening bias. Expectations for further stimulus from Japan and China are growing. The timing for policy tightening in the US has been pushed back. Clearly monetary conditions globally are becoming easier.
The second factor, much aligned with the first, is outlook for inflation and economic growth in Australia. Over the course of 2014 consumer price inflation rose by 1.7%, the lowest level seen since the height of the global financial crisis. And yes, while core inflation increased by 0.7% in December quarter, the annual rate fell to just 2.25%, the lower end of the RBA’s 2-3% target band. Other measures of inflation also suggest disinflationary pressures are building. Wage inflation is running at multi-decade lows and the TD-MI inflation gauge rose just 1.5% in the year to January. All this at a time when the Australian Dollar lost more than 10% in value against the US Dollar, 3% in trade-weighted terms. As an inflation-targeting central bank the RBA will be taking notice. While there have been some signs of economic rebalancing within the domestic economy, building approvals have been strong while consumer credit is trending higher, albeit off a low base, and retail sales have recovered following a mid-year swoon, whether or not they’ll be enough to offset declining mining-sector capital expenditure and lower prices for Australia’s key commodity exports remains debatable. Increasing unemployment, along with subdued levels of business and consumer confidence, further clouds this view.
So what are we likely to see from the RBA following their February monetary policy meeting? Will they cut, or at a very least drop their neutral bias, or will they maintain the status quo? We evaluate the likely, plausible and unlikely scenarios below.
The Likely – RBA holds rates steady, adopts an easing bias.
The RBA Board, under Glenn Stevens’ leadership, are cautious by nature. While there has been plenty of chatter that they have used influential members of the Australian financial media to communicate an upcoming change in rates, the fact remains that they retain a neutral policy stance. Given the perception, in our minds at least, that they have been reactionary rather than proactive in recent years, it’s more likely that we’ll see an adoption of an easing bias rather than an actual rate reduction. By implementing an easing bias it will allow for policy flexibility. They can cut if conditions deteriorate, or, if conditions improve, keep rates steady. It will also help maintain the bid in bond and equity markets and pressurise the Australian Dollar, albeit not in the ultra-short-term.
The Plausible – RBA cuts the cash rate by 0.25% to 2.25%, adopts an easing bias.
A rate cut, along with the adoption of an easing bias, is favoured by markets. They current attach a 63% probability that the cash rate will be reduced to 2.25%. If this occurs it’s certain that the outlook for inflation and domestic economic growth will be downgraded in their accompanying monetary policy statement. Australian bonds and stocks will strengthen while the Australian Dollar will fall. Given markets favour this scenario expect the moves to be modest in nature.
The Unlikely – RBA holds rates steady, maintains a neutral bias.
This would come as a surprise to markets and, unlike Stevens’ belief in December that steady rates will bolster confidence, it’ll likely create more harm than good. Equity markets, having rallied in anticipation of lower interest rates, will sell off as will shorter-dated bonds and bills. The rise in yields will also benefit the Australian Dollar which has been under pressure as rate cut expectations have grown. Should these this expectation be removed, something that will occur if the RBA maintains their neutral bias, the Australian Dollar will scream higher on the back of short-covering and an influx of global monetary flows.