By Michael Witts, Head of Treasury, ING DIRECT

RBA meets the market expectations

Following a combined 75 basis point reduction in the cash rate over the past two months, the RBA left the cash rate unchanged at its meeting on Tuesday.

This outcome was completely in line with market expectations.

Key points from the RBA statement

The RBA noted there had been “a material easing in monetary policy over the past 6 months”.

While there was “no change in the Bank’s inflation outlook”, “maintaining low inflation over the longer term will, however, require growth in domestic costs to slow as the effects of the earlier exchange rate appreciation wane”.

This point highlights the RBA concern on two fronts, namely domestic inflation and productivity.

The chart below highlights that domestically sourced inflation has been running at an annual rate of over 3% for the last several years. While the strength of the appreciation of the currency has seen the price of imported products fall over this period.

This combination has resulted in overall measures of inflation being at the lower end of the RBA 2-3% target range.

The Bank noted that the terms of trade have most probably peaked; as a result further strong appreciation of the currency is unlikely.

Therefore, overall measures of inflation will drift higher in the absence of the currency induced cushion.

In recent speeches the Bank has highlighted the poor productivity growth that has beset the Australian economy over recent years.

Growth in productivity is an effective means to combat domestic sourced inflation.

Equally, the comments from the Bank regarding domestic cost pressures is a warning sign that, in the longer term, they may be prompted to use monetary policy to reign in excessive domestic cost pressures. This is someway off at this stage, but it does highlight the RBA thought process.

Key events since the last RBA Board meeting

Domestic
Immediately following the RBA Board meeting in June, when the RBA cut the cash rate by 25 bps, significantly stronger than expected growth and labour force data was released, surprising markets.

The RBA noted, in the subsequent Minutes, that the June decision was finely balanced.

In hindsight, this would suggest that in view of the stronger than expected underlying economic data, the RBA may not have cut rates in June.

This interpretation would appear to be reinforced by the comments in the statement on Tuesday “there has been a material easing policy over the past 6 months”.

The Bank is highlighting that adjustments to monetary policy involve a substantial lag prior to having a material impact on the real economy. The lag is variously estimated to range from six to nine months.

This stimulus effect is compounded with the expansionary impact of the cash disbursements under the family assistance package. While this funding is designed to primarily offset the costs associated with the carbon pricing scheme, it nevertheless provides a net stimulus to the economy.

In addition, the cessation of the temporary flood levy will see more money flow into consumers’ wallets. The question is, will this be spent or saved?

Global
For most of the past month, it appeared that events were going from bad to worse, as the ongoing European crisis engulfed the Spanish, and to a lesser extent, Italian banking system.

Despite this impression, a number of positive developments occurred over the period;

• Greek elected, at a second attempt, a pro-European government and affirmed the terms of the previous funding packages.
• The European leader’s summit, held at the end of June, was being seen in the same light as previous meetings; lots of talk but seemingly no real progress. Hence, low expectations were held. In contrast, Europe agreed on a framework to separate banking issues from sovereign debt concerns. As always with these plans not only is the devil in the detail, but the implementation risks remain elevated.
• While still early days since this meeting, the market reaction has been more positive than previous outcomes. The next key date is July 9, at which the working details will be presented.

Despite the risks, it appears that Europe is progressing on a recovery blueprint that has credibility with markets. This is an important first step.

June Quarter CPI release

This is to be released towards the end of July and will provide the market and the RBA with further input to the direction of rates. The annual measure is expected to come in at just over 2%, which is the lower bound of the RBA target.

While this will add to the necessary conditions to support a further reduction in the cash rate, of itself, it may not be a sufficient condition.

The Bank will focus on the impact on the domestic economy of the previous monetary and fiscal measures. In particular, measures of consumer spending and indications of continued strength in labour market conditions will be closely watched.

Equally, the progress in Europe will dominate domestic considerations.

Clearly, the RBA has the capacity to reduce rates if needed in response to external events.

Michael Witts

3 July 2012