The RBA decided to leave interest rates on hold at 4.25% at its Board meeting last week.  This was not a complete surprise but went against our forecast of a 25 basis points cut and the vast majority of forecasters in the market, who also expected a cut (34 out of 27 forecasters in the Bloomberg survey). The market had about a 75% chance of a 25 basis points cut priced last Monday. 

On reflection, our forecasts were consistent with the RBA’s decision to leave rates on hold and we should have noted the improved investor sentiment about Europe and the fact that local and international data since the last meeting had not deteriorated (any more than expected in Europe). This point was amplified by the RBA’s little changed forecasts in its quarterly Statement on Friday. 

To summarise the RBA’s statement from last Tuesday they told us
• Growth is likely to be about trend ahead
• Inflation forecasts are in the target range
• Interest rates for borrowers are around their long run averages

Hence, the economy is in its sweet spot so why adjust policy (remembering it will take more than 18 months for the effects of the two interest rate cuts in November and December to work through the system in any case)? 

One interesting thing about Tuesday’s post-meeting statement was that it explicitly said that if economic conditions deteriorate, the inflation outlook would “provide scope for easier monetary policy” i.e. to cut rates again.  But this is a ‘latent’ easing bias, not a signal of intent. 

Another important aspect of the Tuesday statement was the observation by the Board that the exchange rate had risen further, even though the terms of trade had declined. This meant the Trade Weighted Index was somewhat higher than they had previously assumed. 

A plausible conclusion from this is that monetary conditions have tightened a little with the rise in the currency. 

The RBA also noted higher bank funding costs, compared to the situation in mid 2011. 

Where does this leave us?

Basically a rate cut could still happen due to the following factors:
• If higher mortgage rates such as we've already seen worries the RBA)
• AUD rises further (to 1.10 say or above), without accompanying increases in commodity prices (a tightening in financial conditions)
• Unemployment jumps to say 5.5%
• Inflation in Quarter 1 is significantly below expectations
• Europe has a major financial meltdown

If Europe implodes, the RBA could cut rates hard but this is not our central case. 

A mixture of the other four factors could see a rate cut in May, or possibly even earlier.  This is our current call but we give it only about a 50:50 chance. 

So, the easing cycle looks to be nearly finished, unless there is a crash in Europe. 

The RBA’s quarterly statements provide a compendium of information and analysis of the Australian and international economic environment.   

Gross domestic product (GDP) for the year to June 2012 was cut from 4% in the November Statement to 3½% in the February edition.  Further out, from December 2012 and onwards, GDP forecasts unchanged at 3 3½% out to middle 2013 and then 3½-4% out to the middle of 2014.  The latter set of forecasts implies the economy is running right up against its speed limit of long run trend and probably a touch over.

The all important underlying inflation forecast were cut by one quarter of 1% for the year to June 2012, underlying consumer price index (CPI) now at 2¼% and headline CPI at 1¾%, so very low.  Looking ahead out to the end of 2013, inflation comfortably in the target band, running at 2½% excluding the carbon tax, but then rising to the top of the target band 2¼-3%, by the end of the forecast period in June 2014. 

The tone of the RBA commentary is generally positive about the outlook:

 “   There has been a general improvement in sentiment over the past month, following further measures by the European Central Bank and European Governments”

 “... the US economy has improved over recent months”

 “...China has moderated, as intended”

“...the Australian economy continues to record moderate growth”

 “.. Overall, the underlying inflation (excluding the effect of the carbon price) is forecast to remain within the target range over the next few years”. 

There are risks to both sides of the RBA’s ‘on target’ inflation outlook.  

The RBA says the biggest risk is from a disorderly sovereign debt default in Europe, triggering a severe recession, which would see inflation fall. 

On the upside for inflation, the RBA says that recent outcomes have been helped by the appreciation of the Aussie dollar, whereas non-tradeables inflation has been at a higher rate than is consistent with inflation at the middle of the target range.  If the currency does not keep appreciating, this means the local economy will need to reduce cost pressures, including through higher productivity. 

The RBA’s forecasts are very similar to ours over 2012 so their release suggests that our post-February Board meeting call - possibility of one more cut ahead - remains valid. 

Lower rates ahead will require a significantly softer labour market (unemployment to 5½%), a surprisingly low CPI for the March quarter (due late April); and/or tighter financial conditions via the banks deciding to raise borrowing rates because of higher funding costs and or a higher Australian dollar, not supported by rising