28 April 2016
by Jacob Greber

Reserve Bank on collision course with Morrison after deflation shock

The Reserve Bank of Australia might intrude on the Turnbull government's crucial pre-election budget on Tuesday, with an interest rate cut that could trigger alarm about the health of the economy.

Financial markets were left reeling after official data showed the economy was in a deflation-like state last quarter, thanks to plunging global oil prices and lacklustre wages growth.

In a fresh sign the economy might be far more fragile than official Treasury and Reserve Bank forecasters assume, consumer prices shrank 0.2 per cent from the December quarter, for an annual increase of 1.3 per cent. It was the weakest core inflation on record.

The falling prices, which fly in the face of more upbeat signals from the labour market, triggered a selloff in the dollar by more than 1¢, to US76.05¢ from US77.60¢.

Afterwards, investors put the chance of a historic Reserve Bank rate cut on budget day at 55 per cent, up from 12 per cent on Tuesday.

The spectre of a deflationary trend in prices has sent Reserve Bank officials scrambling to reassess the justification for more monetary policy stimulus.

Even if the central bank holds fire next week to avoid drawing attention away from Treasurer Scott Morrison's first budget – and what is widely expected to be the Turnbull government's unofficial campaign launch – there is likely to be pressure for a cut in June, just weeks before the probable July 3 federal election.

Capacity to do something
Mr Morrison said low inflation was not uncommon among developed countries but Australia's central bank had the capacity to do something about it by cutting rates.

"Unlike most other developed countries, Australia has room to move to address low inflation if needed. The independent Reserve Bank's cash rate is at 2 per cent, and I have complete confidence that they are closely considering this data," he said.

The sudden speculation about the Reserve Bank becoming embroiled in the pending election campaign is familiar territory for Reserve Bank governor Glenn Stevens, who started his decade-long term in 2007 with a pre-election rate hike that was seen to have cruelled John Howard's election hopes.

For the Turnbull government, the prospect of a June rate cut might be a double-edged sword, assisting debt-burdened households while potentially creating fresh reminders of why the economy is still below average.

In 2013, then opposition leader Tony Abbott and shadow treasury spokesman Joe Hockey characterised rate cuts in that year as being driven by deep concerns about the state of the economy under Labor.

Labor shadow Treasury spokesman Chris Bowen said Labor would avoid repeating such negativity in the case of a pre-election rate cut in 2016.

"Labor's position on monetary policy is the same now as it was in 2013 and earlier," Mr Bowen said. "That is, that we don't comment on movements in monetary policy and the RBA should continue making such decisions without fear or favour."

Collision course with budget
The Reserve Bank's regular board meeting on the first Tuesday of the month was put on a collision course with the budget when Prime Minister Malcolm Turnbull moved the date forward by a week.
Two key measures of core inflation that are used to judge the Reserve Bank's 2 to 3 per cent inflation target slowed from an average of 2 per cent in 2015 to 1.6 per cent in the quarter, the weakest rate on record, Australian Bureau of Statistics data dating to 2003 show.

National Australia Bank was the first of the big four to say it now expects the Reserve Bank to cut rates next Tuesday. Other banking analysts said they were reviewing their forecasts for no rate change.

"There seems to be little major downside to providing some further support to the economy – though of course with an election just about to kick off, such a decision will likely attract some allegations of political favouritism, though no more so than the alternative, whereby the bank feels rates need to be cut and does not do so," JPMorgan economist Sally Auld said.

Reserve Bank officials preparing next week's board papers are faced with the challenge of judging whether Wednesday's shock result is a rogue report or points to renewed economic weakness.

Headline consumer prices fell 0.2 per cent in the March quarter – the first decline since late 2008, when the global financial crisis erupted on Wall Street – and rose just 1.3 per cent from a year earlier, dragged lower by plunging fuel and fruit prices.

Domestically driven forces
Of crucial importance to Reserve Bank officials will be distinguishing between the impact on the weak inflation result caused by falling global crude oil prices and more domestically driven forces, chiefly wages.

So-called non-tradables inflation, which is heavily affected by local cost pressure, rose by a soft 0.4 per cent in the quarter, with the annual rate cooling sharply from 2.3 per cent to 1.7 per cent – a 16-year low.

The figures suggest wages growth, currently tracking at a record low, is unlikely to rebound in the near-term.

While this has clearly helped support the jobs market by making it more attractive for employers to retain and hire extra staff, the consequences for the government mean it might collect less income tax revenue than expected.

With Mr Morrison preparing to offer an income tax cut to average earners in the budget, Wednesday's figures also point to revenue from so-called bracket creep being less than anticipated.

The inflation shock coincides with fresh warnings that the budget will never return to a structural surplus. KPMG chief economist Brendan Rynne, in research to be published on Thursday, says when cyclical factors are removed from the budget, low productivity and falling average hours worked per employee will continue to drag on the economy.

"It's never coming back into balance," says Mr Rynne, whose research outlines about 30 tax and spending-cut options that would generate an annual $12 billion improvement in the fiscal bottom line, including on education, superannuation, health and welfare.

Unlike the recent Committee for Economic Development of Australia report, which relied largely on taxes to restore the budget, KPMG's suggestions rely on about $1 of extra tax for every $2 of spending cuts.