No rate cuts yet

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By Michael Knox

Job title:

Chief Economist and Director of Strategy

Date posted:

28 January 2015, 2:02 PM

We are firmly of the belief that the RBA needs to cut rates. The reason we think this is because the yield curve is too flat.

At the time of writing, Australian 90 Day Bank Bill yield of 2.65% is actually higher than the Commonwealth 10 year bond yield of 2.56%.

This means that the yield curve is at best flat and in fact modestly inverted. We think this means that monetary policy is too restrictive.

We think that Australia needs a yield curve where ten year bond yields are at least 100 basis points higher than the cash rate.

A good way to get there would be to cut the cash rate by at least 50 basis points.

How the RBA thinks

This is not the way the RBA thinks. The RBA is an inflation targeting Central Bank. It moves the real short rate in response to movements in inflation.

Many had hoped that the release of the December quarter CPI would generate low enough levels of core inflation to allow the RBA to begin its task of cutting rates.

The consensus forecast was that most measures of core inflation would come in at around 0.5%. This would mean a year-on-year core inflation rate of 2%.

Given that the RBA targets inflation in the range of 2-3%, a core inflation rate of 2% as thought by many, including us, as enough for the RBA to cut at least once. That is not how the number came in.

Core Inflation

There are three measures of core inflation. The RBA prefers the "trimmed mean" or the "weighted mean". Some long term practitioners prefer the "all groups excluding volatile items".

For the RBA to cut rates, the trimmed mean and the weighted mean needed to be at 0.5% or lower. The bad news was that the trimmed mean came in at 0.7%, giving year-on-year inflation of 2.2%. The weighted mean came in at 0.7%, giving year-on-year inflation of 2.3%.

Even the all groups excluding volatile items came in at 0.6%, giving year-on-year inflation of 2.1%.

The market quickly concluded that none of these numbers were low enough for the RBA to cut rates. There was a quick bounce in the Australian dollar relative to the US dollar of around half of one US cent. The problem with Australian inflation for the quarter was the increase in the cost of services.

When we look at the goods and services series, we see that the goods component fell by 0.3% for the quarter, giving year-on-year goods inflation of 1%. The services component rose by 0.8%, giving year-on-year services inflation of 2.7%. We need more time for services inflation to fall to a level where the RBA will cut rates. The RBA needs to act. Let us hope when the RBA does act, it is not too late.

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