Reserve Bank of Australia lowers policy rate to new record low, aiming to stave off deflation

Rate cut justified by lower inflation, indications of stabilisation in the housing market

According to the post-decision statements from Stevens, the Reserve Bank of Australia (RBA) Board felt that the 25-basis-point reduction in the official cash rate target would improve the prospects for sustainable growth in the economy, as well as returning headline inflation to the bank's 2–3% target range with time. Stevens noted that domestic economic growth continues at a moderate pace despite a large decline in business investment, which can largely be attributed to the mining sector. Growth instead remains supported by private consumption and exports, which continue to grow at or above trend. Stevens further noted that low interest rates are supporting domestic demand by allowing financial institutions to lend for " worthwhile purposes". Deflation remains the pressing issue for the RBA as well as other major central banks, as subdued global demand is expected to persist. The weaker-than-expected June-quarter inflation reading (see Australia: 28 July 2016: Australia records lowest annual inflation since Q2 1999, making RBA rate cut likely in August ), when combined with continued weakness in domestic wage growth and recent appreciation of the Australian dollar, increases the deflation risk for Australia; however, in the near term, rising oil prices and an increase in the tobacco excise tax on 1 September will lift headline inflation. Nonetheless, underlying weakness in domestic and global demand will keep headline inflation below the RBA's target through the end of 2016.

The sole factor that could have derailed this month's interest rate cut was the housing market. The RBA has been warning about the housing market for some time, but in the August statement Stevens expressed confidence that improved supervisory measures implemented during the past year would prevent the interest rate cut from increasing risks in the housing market. The governor also indicated that a number of lenders are becoming increasingly cautious about lending to particular sectors, with the RBA's latest data on investor housing credit showing year-on-year contractions of 3.0% for June. Also working in favour of the housing market is significant apartment-construction activity following a substantial surge in non-house dwelling approvals from late 2012 into early 2016. This will provide significant relief to the rental market by lowering rent costs, which could mean that renting becomes more attractive proposition than home-ownership. The RBA will continue monitoring housing prices closely, as these are elevated and continue to rise, albeit at a slower pace. It should be noted that the four major banks passed on only 10–14 basis points of the RBA's cut to their variable-rate owner-occupier mortgage products rather than the entire 25 points, owing to concerns about funding costs and capital requirements. The holding-back of the rate cuts by the banks further limits the impact of the interest rate cut on the housing market.

Reining-in of Australian dollar appreciation could limit further worsening of the trade balance

In highlighting the strengths of the Australian economy, Stevens noted that the weaker Australian dollar versus 2013 is helping the tradable sector. However, Stevens talked down the currency factor by indicating that the recent appreciation of the Australian dollar could undermine recent improvements in the traded sectors, and thereby disrupt the economy. This is true for less competitive sectors of the economy (especially manufacturing), while Australian commodity exporters will see reduced profits in Australian dollar terms, owing to their products being sold on USD terms.

The June trade data pointed to a worsening of the goods and services trade balance, although not all of this deterioration can be attributed to currency appreciation during the course of the month. Export performance remained sluggish, dragged down by volatile non-monetary gold exports as well as coal products; sluggish growth in iron ore, metals, and machinery exports were not sufficient to offset these weaknesses. Imports were surprisingly strong as consumption-goods imports surged, led by the broad category of "consumption goods not elsewhere specified (n.e.s)", with non-industrial transport equipment (largely motor vehicles) also recording strong growth. Consumer import demand is the category of trade most susceptible to currency appreciation. Meanwhile, capital-goods imports surprised on the high side for a second consecutive month, led by machinery and industrial equipment imports, as well as telecommunications equipment.

Outlook and implications

IHS Markit does not expect any further moves by the RBA this year. We expect inflation to have troughed in the June quarter, with the tobacco excise tax increase and rising oil prices set to boost inflation in the coming quarters; this factor – together with an expected return to currency depreciation by late 2016 as a result of expectations of monetary tightening by the US Federal Reserve Bank – means the Australian headline inflation rate should edge back into the bank's inflation target range by early 2017. If the latest rate cut were to create a resurgence of rapid house-price appreciation, the Australian Prudential Regulation Authority (APRA) would need to implement further prudential measures to address this, in order to limit the need for rate hikes by the RBA.

It is expected that export performance in nominal terms will remain muted over the coming months owing to weak global demand, with improvements more likely to be led by new liquefied natural gas (LNG) exports coming online than any weakening of the Australian dollar. Meanwhile, imports need to be monitored closely; the growth in consumption-goods imports hints at healthier private consumption, but that demand is being met with imports, thus mitigating the benefits to the Australian economy. Recent growth in capital-goods imports may be related to the winding-down of some remaining mining-sector projects, as well the ongoing expansion of the National Broadband Network (NBN), but should be monitored for indications of other sectors boosting their investment activities.