Room for more cuts

About the author:

Author name:

By Michael Knox

Job title:

Chief Economist and Director of Strategy

Date posted:

06 May 2015, 12:01 PM

In the blog that Ben Bernanke has recently begun at the Brookings Institute, he says that the first objective of a central bank is full employment. He notes that the central bank attempts to get the level of excess resources (of labour and capital) in an economy as low as possible without causing the economy to overheat. Overheating in central bank terms is rising inflation.

On 5 May 2015, the RBA cut the Australian cash rate to 2.0%. It noted that “the Board judged that the inflation outlook provided the opportunity for monetary policy to be eased further.”

Yes, that is true. Still, the first objective is to get excess supplies of labour down towards long term equilibrium levels. We have noted before that the current level of Australian unemployment of 6.2% is still close to the highest levels of unemployment this century. Normally we would expect unemployment in Australia to fall towards 5% or lower before business expansion caused significant inflation.

With unemployment at 6.2% we expect that wages growth and core inflation will continue to ease. This means that continued downward pressure on inflation is likely to allow the RBA more room to cut rates in coming quarters. Our model of the Australian cash rate is shown in Chart 1 above.

Two things are notable. The first is that the RBA allowed itself to fall behind the curve. After cutting rates to provide a supportive environment in 2012 and 2013, the RBA decided to sit on its hands in 2014.

Unfortunately, Australian export commodity prices continued to deteriorate while the RBA rested. This allowed further declines in national income.

The cash rate has only now caught up with our model estimate at 2%. Our model tells us that the RBA has only just caught up with the deterioration in fundamentals that occurred in the second half of 2014.

The RBA may now wish to again get ahead of the curve. We think that further downward pressure on inflation will give them the opportunity to provide more stimuli by further cuts to the cash rate in the quarters that lie ahead.

More information

Morgans clients can login to view more Economic Strategy reports by Michael Knox. Alternatively contact your adviser or nearest Morgans office.