A cut is likely, but it’s a close call: HSBC's Paul Bloxham

A cut is likely, but it’s a close call: HSBC's Paul Bloxham
A cut is likely, but it’s a close call: HSBC's Paul Bloxham
The RBA has been reluctant to consider cutting its cash rate further.
It has made this fairly clear in recent public commentary. Business conditions are improving, employment is picking up, the unemployment rate has stabilised, and GDP growth seems likely to have lifted in Q3, after a weak Q2 print. The lower AUD is providing support for the rebalancing act. The RBA is also concerned about exuberance in the property market.

However, three key things have happened in the past month that mean the RBA may, nonetheless, be forced to cut. First, in response to higher regulatory capital requirements, Australia’s four major banks lifted their mortgage rates by an average of 17.5bp. This, alone, was unlikely to see the RBA consider cutting its cash rate, given concerns about exuberance in the housing market, but it has led to tighter local financial conditions, which may not be desirable at this point in the cycle.
Second, the underlying inflation measures surprised to the downside, with the q-o-q rates falling to 0.3% and the y-o-y rate at 2.2% (market had 2.4%). The RBA was forecasting underlying inflation to lift to 2.5% y-o-y by Q4, which now seems unlikely. Third, the US numbers have been weaker recently, which has seen market pricing suggest that the Fed may not lift its policy rate this year, which is a possible upside risk for the AUD.

Together, these factors strengthen the case for the RBA to cut. The most powerful argument is that inflation is lower than had been expected. This tells us that there is more spare capacity in the economy than previously thought. Although the recent lift in the activity indicators should mean growth lifts and generates some inflation, the bigger risk is undershooting the inflation target, not overshooting. Although we remain optimistic about the rebalancing of growth and expect growth to pick up next year, we think the path of least regret is for the RBA to cut further to ensure than inflation remains on target. 
A cut is likely, but it’s a close call: HSBC's Paul Bloxham

Inflation surprised to the downside

The Q3 inflation print was surprisingly weak. Both of the RBA’s preferred underlying measures – the trimmed mean and weighted median – were 0.3% q-o-q, against a market expectation of 0.5% q-o-q (Chart 1). The y-o-y rate of underlying inflation fell to 2.2% and underlying inflation has been below the target band in annualised terms over the past six months (Chart 2).

Weakness in inflation was fairly broad-based across the components. Although the lower AUD should start to lift imported inflation soon, there were few signs of this effect in the Q3 numbers (Chart 3). Tradables inflation rose by only 0.3% q-o-q and was still running at a negative rate over the year of -0.3%. Domestically produced (non-tradables) inflation was also steady, running at a below-average pace of 2.6% y-o-y. Headline CPI inflation has now been below the target band for four quarters on a y-o-y basis (Chart 4).

The RBA’s last set of forecasts had underlying inflation lifting to 2.5% by Q4 2015, which now seems unlikely. The central bank is likely to revise down its inflation forecasts in next week’s official statement. 

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A cut is likely, but it’s a close call: HSBC's Paul Bloxham


Growth is lifting but spare capacity remains

At the same time that inflation has surprised to the downside, there are on-going signs that growth is continuing to rebalance towards the non-mining sectors. This has been supported by the ongoing effect of low interest rates and the lower AUD. This rebalancing of growth is creating jobs and lifting broader business conditions (Chart 5). Employment growth is running at 2.0% y-o-y, up from 0.5% a year ago and the NAB survey shows that business conditions are improving, led by the services sectors. The lift in jobs growth has been sufficient to get the unemployment rate to stabilise between 6.0-6.4% over the past 16 months (Chart 6).

However, as yet, the pick-up in activity has not been sufficient to get the unemployment rate to fall. The spare capacity that remains in the labour market has kept wages pressures contained, which helps to explain why non-tradables inflation is yet to pick up. Although the RBA is no doubt pleased that the unemployment rate has stabilised, it needs to fall to start generating upward pressure on inflation. Although the timely indicators of the labour market have been lifting recently, the RBA’s last set of forecasts had the unemployment rate broadly steady over the forecast horizon and we doubt there is enough momentum as yet to see the RBA revise its unemployment rate forecast to a falling profile.

Mortgage rates have been lifted by the major banks

So inflation is lower than expected, suggesting that there is more spare capacity in the economy than previously anticipated and, although growth is improving, it has not been sufficient to push the unemployment lower and, thus, absorb the spare capacity.

This month has also seen local financial conditions tighten. This occurred because Australia’s four major banks lifted their mortgage rates in response to higher regulatory capital requirements. The simple average of the increase in mortgage rates was 17.5bp.

We see the RBA as unlikely to have been surprised by this move. After all, the authorities have been seeking to tighten prudential settings to slow activity in the housing market and holding more capital against the mortgage book has become a part of this story. In tandem, the government has been running its Financial System Inquiry, which has sought to make the banks ‘unquestionably strong’ by forcing them to hold more capital. 

To some degree, the RBA may also be quite content to see slightly tighter conditions in the new housing lending market, given the central bank’s concerns about exuberance in the housing market. However, it is worth keeping in mind that the lift in rates feeds through to the whole mortgage book (including existing loans) because about 90% of Australia’s mortgages are at variable rates. It is not clear that the RBA necessarily wants broadly tighter financial conditions at this point in the cycle.

Adding the downside surprise to underlying inflation of around 20bp to the tightening in financial conditions delivered by the major banks (17.5bp on the mortgage book) means that real interest rates have been tightened by around 30bp (keeping in mind that mortgage lending is around two-thirds of the total).

RBA tactics

One option is for the RBA to do nothing. The central bank would thereby accept that inflation is as bit lower than it had expected, revise down the inflation forecast profile, and acknowledge that mortgage rates are a bit higher, but business lending rates are still low. The change in bank rates may actually have got the RBA closer to a more ideal policy setting (slightly tighter housing lending conditions, while business lending rates remain unchanged).

However, the risk with this strategy is that the Q3 inflation numbers provide a warning that demand is not yet strong enough to lift inflation back to target. If the low Q3 underlying inflation print was followed by another weak print in Q4 (in February 2016), then underlying inflation could fall below the bottom of the target band in y-o-y terms. By then, cutting rates in response would risk getting behind the curve.

On the flip side, there is little to stand in the way of cutting the cash rate further. The risk of undershooting the inflation target surely significantly outweighs the risks of overshooting at this point. Although the labour market is improving, the unemployment rate is not yet falling. Concerns about the housing market would remain, but the net effect of a 25bp cut would be largely offset by the recent lift in mortgage rates by the major banks, leaving financial conditions similar where they were a month ago. 

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A cut is likely, but it’s a close call: HSBC's Paul Bloxham



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