RBA Preview: another lineball decision

May 4, 2015

It has been a tumultuous few months for the Reserve Bank of Australia (RBA), with the central bank continuously defying market expectations to reduce the official cash rate. The bank has been content to remain in wait-and-see mode and conserve ammunition as it assessed the impact of prior policy loosening. Board members argued that monetary policy was already loose enough to support economic growth and the weakened positive impacts of further monetary policy loosening didn’t outweigh the risks to the property market. This wait-and-see approach has been supported by the release of stronger than expected labour market, retail sales and inflation numbers over the last month.

Australia’s unemployment rate dropped to 6.1% in March from a revised 6.2% in February, as the economy added 37.7K jobs last month, more than doubling market expectations, and employment growth in February was revised much higher (42K vs. 15.6K). Not only did the economy add a substantial amount of jobs over the last two months, they largely considered of full-time employment which is more indicative of a healthy economy than persistent growth in part-time employment. 73.4K full-time jobs were added in February and March alone, with 31.5K being added in March and February’s figure was revised to 41.9K from 10.3K previously. Also, the labour force participation rate jumped to 64.8% in March from a revised 64.7% in February (the un-revised figure was 64.6%).

Also, headline Q1 CPI growth was 0.2% q/q and 1.3% y/y, beating an expected 0.1% q/q increase but matching the market’s expectations for a 1.3% y/y gain. The more important core-inflation figures were also slightly better than expected, with weighted mean CPI jumping 0.6% q/q and 2.4% y/y, beating expected increases of 0.5% and 2.3% respectively. The other measure of core inflation, trimmed mean inflation, came in at 0.6% q/q, matching expectations. While these numbers keep the door open for further policy loosening, the stable rate of consumer price growth within the RBA’s target range means it can opt to remain on the sidelines for the time being.

However, it may finally be time for the RBA to loosen monetary policy amid a lack of economic activity in non-resource parts of the economy and a strengthening exchange rate, despite last month’s encouraging retail sales and labour market data. According to the OIS market Down Under, there’s around an 80% chance – up from around 60% at the end of last week - that the bank will lower the OCR to 2.00% and 24 of 28 economists surveyed by Bloomberg forecast the RBA to cut the official cash rate by 25 basis points.

One reason why the market is so dovish this time around is because of some recent strength in the Australian dollar and the need for a lower exchange rate to promote economic activity. Since the bank last met the AUD has fallen further away from what the RBA classifies as it fundamental value, largely because it hasn’t sunk alongside commodity prices recently. Even a somewhat dovish outlook surrounding interest rates in Australia isn’t enough to deter yield seekers, as it’s nothing compared with extreme monetary policy loosening in other parts of the world. With this at the back of everyone’s mind, if the RBA doesn’t cut interest rates this time around it risks sparking a serious rally in the Australian dollar, especially given how dovish the market is about Tuesday’s meeting. So, the bank may have no choice but to lower the OCR and verbally assault the aussie once again.

What does this mean for the Australian dollar?

With the vast majority of the market expecting the RBA to loosen monetary policy on Tuesday, AUD bears are at risk if the bank elects to remain on hold. In this case we would expect to see a substantial and sustained rally in the Australian dollar, possibly creating a new range above 0.8000 in the near-term. The RBA, however, would be acutely aware of this and it may factor into its policy decision. If the bank does cut interest rates and verbally assaults the aussie once more it may succeed in pushing AUD closer to what the RBA sees as its fundamental value.

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