Softer inflation gives the RBA room to maintain loose policy

A drop in inflation in Australia has provided the Reserve Bank of Australia with more room to leave interest rates at lows levels for an extended period of time. Consumer prices rose 0.5% q/q last quarter, bringing year-on-year growth to 2.3%. This is slightly better than an expected increase of 0.4% q/q and a headline rate of inflation of 2.25%.

Overall inflation now sits at its lowest level since Q3 last year as prices for clothing and communication weighed on the Consumer Price Index. Nonetheless, the RBA is more concerned about the two measures of core inflation, which both show that inflation is sturdier than the headline number suggests, albeit only mildly stronger.

Trimmed mean CPI rose 0.4% q/q and weighted median CPI jumped 0.6% q/q, with the former missing expectations by 0.1% due to a downwards revision of Q2’s data and the latter beating expectations by 0.1%. This brings the two core measures of inflation to 2.5% and 2.6% y/y respectively.

Q3’s inflation data shows us that core inflation is in the middle of the RBA’s target range of 2-3%, thus it’s unlikely to have much of an effect on monetary policy. The RBA is likely to use this data to maintain its already accommodative stance for monetary policy, at least for the time being.

The question is will the RBA’s next move on interest rates be to the upside or the downside? Given present indicators for growth, a soft labour market and a still historically high Australian dollar, the RBA may be able to justify another interest rate cut. This would help to weaken the Australian dollar and support economy activity.

However, the bank is becoming more vocal about the risks of a possibly overheated property market. RBA deputy governor Lowe remarked earlier this week that “the longer it (low rates) runs without a pick-up in the appetite for real investment, the greater is the potential for new risks to develop.” Lowe was referring to the risks associated with asset price bubbles if certain sectors get too far ahead of the real economy.

Furthermore, the RBA believes that the AUD will fall further over time, thus it has less imputes to reduce rates at the moment. The aussie may in fact be the most crucial factor in the setting of monetary policy in Australia. If AUD fails to materially weaken and growth is predicted to remain below trend for longer than the RBA currently expects, it may be forced to lower interest rates.

AUDUSD

AUDUSD initially lost some ground as the first piece of the inflation puzzle was released, which was the slightly lower than expected trimmed mean numbers. Yet, the pair quickly retraced these loses as the rest of the inflation numbers were released. Overall, the pair remains in no-man’s-land at the moment. It ins’t looking strongly bullish or bearish at this stage. Yesterday’s post-China GDP gains have been eaten away by widespread USD strength.