Background:
Given the change in policy direction delivered on Tuesday, today’s SoMP from the Reserve Bank of Australia is likely to attract a greater than normal level of attention. For the markets, the key question is whether the 25bp cut was a “one-and-done” fine-tune or the start of an easing cycle. Going into today’s statement, the market has an additional 100bp of easing fully priced in out to June 2012, with a 25bp cut for the December meeting.
The relatively brief statement that accompanied the rate decision on Tuesday certainly did not telegraph an urgent need to act again. That said, the door is ajar for further action, given that Tuesday’s decision was described by the RBA as a move to a “more neutral stance of monetary policy” rather than a neutral stance.
For us, the November rate cut should be seen as the end of the tightening cycle rather than a fine-tuning of policy. At no time over the past 20 years has the RBA changed policy course and not delivered multiple moves. Like everyone, the RBA can make mistakes. Nonetheless, history would suggest the RBA tends to lessen the chances of a mistake by waiting until it believes it needs to act in a meaningful way – that is, by more than 25bp. Time will tell whether Tuesday’s move has followed the central bank’s typical modus operandi.
The notion that the RBA is likely to follow it usual path and deliver further easing was strengthened by developments on the commodity price front. First, the RBA appeared definitive in declaring that the terms of trade had peaked. Secondly, two hours after the rate decision on Tuesday the RBA released its October update for the commodity price basket. It unexpectedly declined 4.3% m/m in October (7.3% below peak) in USD terms. We say unexpectedly because the current price drop is unlike the situation in 2010, when the 35% decline in spot iron and coal prices had virtually no impact on the RBA commodity price index. In essence, the pass-through from spot to contract prices now seems much faster.
Bottom line:
In our opinion, the key takeaways are:
- The terms of trade have peaked as the RBA had been expecting. That said, the central bank acknowledged that “recent significant falls in the price of iron ore suggest that the decline could be happening a little faster than earlier expected.”;
- GDP growth in y/y terms has been downgraded by 50bp across the forecast horizon;
- Underlying inflation over the forecast has been aggressively downgraded by 50-75bp across the board. That said, most of this appears attributable to the reweighting of the CPI basket; and
- The technical assumption the RBA has based its forecasts on is an unchanged cash rate. The RBA typically assumes a market profile for interest rates, unless it disagrees. This appears to be one of those occasions, like the August SoMP.
Accordingly, we believe today’s statement appears to be relatively benign for interest rates at this stage given forecast updates. Our modelling suggests the RBA tends to target GDP growth and underlying inflation 12 months ahead when setting policy. Its December 2012 forecast for underlying inflation is 2.5% (excluding carbon tax), and it projects GDP growth of 3.25%. That suggests policy is basically appropriate at this point in time.
From our perspective, the acknowledged “little faster than earlier expected” decline in commodity prices opens up the potential for growth and inflation undershoots. With spot prices significantly below contract prices for the bulk commodities, iron ore and coal, it signals a bias for the RBA’s commodity basket price to continue to decline quickly over the near-term unless a rebound in the spot price occurs. This in turn poses risks to to mining capex. The RBA acknowledged this in the “Risks” section stating that:
“Commodity markets could be expected to weaken and growth in domestic incomes would be lower. While there is a large pipeline of committed LNG projects that would be expected to continue, some planned expansions to coal and iron ore capacity could, in a downside scenario, be delayed. It is also likely that there would be a depreciation of the exchange rate, which would provide some offset for the economy. Overall, however, demand growth could be expected to be weaker than in the central forecast.”
In sum, the RBA’s forecast profile does not appear to support market pricing. Interestingly, Figures 3 and 4 appear to paint a more negative fundamental backdrop. Moreover, further weakness in contract commodity prices, as seems likely, poses significant downside risks to the RBA’s growth forecast. The December 2011 GDP growth forecast of 2.75% y/y is a case in point. 2.75% implies 1.2% q/q for Q2, Q3 and Q4. For that reason, we continue to believe further easing is likely as the income effects of weaker export income, compounded by its lagged impact on capex, take a toll on economic activity. We will continue to monitor the RBA commodity price index and adjust our interest rate profile accordingly.
Details:
Figure 1: RBA forecast table (versus August SoMP)
Figure 2: Real GDP growth (% y/y), including forecasts
Figure 3: Underlying inflation (% y/y), including forecast
Figure 4: Changes in RBA’s assessment of key offshore macroeconomic variables
Figure 5: Changes in RBA’s assessment of key onshore macroeconomic variables
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