Inflation ‘much weaker’ than RBA’s target band

Jul 2016 - News

The June inflation data, which are broadly in line with economist forecasts, isn’t enough to convince the market that the Reserve Bank will cut the cash rate to 1.5 per cent when it meets on Tuesday.

But the reality is that the reading does confirm that inflation remains low, and lower than the Reserve Bank would like.

Headline inflation is running at its slowest pace since mid-1999 and underlying inflation is at a record low, CBA economists point out with an annualised inflation rate of 1.25 per cent for the first half of the year, its well below the RBA’s 2 to 3 per cent target.

BT Investment Management’s Vimal Gor says that while the numbers came in on consensus “they were still very weak and much weaker than the target band”.

“Both tradeable and non-tradeable sectors were weak and it’s likely this will continue going forward.”

Heading into the data release, traders were pricing in a 65 per cent chance of an August rate cut. That has now moderated to 50 per cent, which ANZ believes is a better reflection of the true odds that the RBA will move on interest rates.

One point to consider is that when the Reserve Bank revised its inflation forecasts downwards in the May Statement of Monetary Policy it used the market expectations of lower interest rates to conclude that inflation would remain stubbornly low (energy prices and the currency is slightly higher which CBA believes is offset by stronger GDP numbers).

On that logic, the RBA has already baked in a rate cut and still believes inflation will be below its target for some time.

The market reaction was to price in a slightly lower chance of an August rate cut, which had offered marginal support to equity and bond markets.

While the Australian dollar initially jumped on what was a modestly higher CPI print, the gains proved to be muted as a cut was firmly on the table.

The only way is down

 In the bond market there was an orderly and modest 3.5 basis point increase across the yield curve, with the 3-year rate trading at 1.54 per cent and the 10-year at 1.96 per cent.

The bond proxy sectors – utility and listed property – were weakest on the back on the low inflation reading – falling by 1.6 and 1 per cent.

For currency and bond traders there is more water to pass under the bridge before the Reserve Bank meets next Tuesday with both the Federal Reserve and the Bank of Japan meeting.

Both have the potential to trigger significant market moves, particularly a hawkish message from the Fed that they’re serious about pushing rates higher.

 For now though the bond bulls that have maintained that the only way is down for the RBA cash rate are sticking firmly to their bets.

“The global deflationary pulse that is sweeping across the world from Asia is now clearly hitting Australia. With low inflation, low growth and a weakening labour market the question is when the RBA cuts not if,” says BTIM’s Gor.

What investors in property and shares should do about the prospect of falling interest rates and weak inflation is tricky.

Low and falling long term interest rates have until now helped to propel asset prices and equities.

 But with the prospect of persistently weak inflation, the income generated by some of these investments may become increasingly challenged.

Lower price growth generally means lower profit growth for companies, while lower wage growth puts a cap on rental growth.

For investors deploying long term capital or seeking to maintain their investment income, we may be reaching a point where the risks of lower inflation outweigh the prospect of potential gains in asset prices that can be achieved.

 

Trackback from your site.

Leave a comment

Our panel of lenders

  • Adelaide-Bank
  • Amp
  • Anz
  • Bank-Of-Melbourne
  • Bankwest
  • CIMB
  • Citibank
  • Homeside
  • Commonwealth Bank
  • DBS Bank
  • Firstmac
  • Heritage Bank
  • Homeloans
  • ING Direct
  • LA Trobe
  • Liberty
  • NAB
  • Macquarie Bank
  • Me Bank
  • OCBC
  • Pepper Financial Services Group
  • St. George Bank
  • Suncorp Bank
  • UOB
  • Westpac
Call or chat