Here comes a rate cut

The odds of the Reserve Bank (RBA) cutting the official cash rate tomorrow have shortened, after retail sales remained flat in June.

Retail sales were flat at 0% for June, after a revised 0.2% increase in May and 0.1% decline in April. Economists had been expecting a 0.4% rise in June. The Australian dollar fell to a new three-year low of 88.58 US cents after the data was released, on expectations that the RBA is more likely to lower the official cash rate at its monthly board meeting tomorrow.

Markets are now virtually asking how big will the cut be rather than whether the central bank will cut. Financial markets are pricing in a 91% chance of a rate cut after the weak retail sales results. A 0.25% cut to 2.5% is still the favoured reduction, but the chances of a 0.5% drop are rising.

Consumers aren’t responding to rate cuts as they have in the past, refusing to go shopping and instead paying down their debts, and accumulating savings in bank accounts. Food retailing continues to be the strongest contributor to growth, rising 0.2%, suggesting consumers are staying at home more.

For struggling retailers like David Jones Limited (ASX:DJS), Myer Holdings (ASX:MYR), JB Hi-Fi Limited (ASX:JBH) and Harvey Norman Holdings (ASX:HVN), the news suggests the weak retail conditions could continue for some time.

Economists have also suggested the Australian dollar is still too high, and needs to drop further. RBA Governor Glenn Stevens noted last week that despite the dollar falling below US 90 cents, it had done little to change the outlook for inflation.

Foolish takeaway

Many economists are now suggesting that at around 80 US cents, the Australian dollar would start to reinvigorate the economy, helping our exporters, and reducing our spending on imports as their prices headed upwards. I wouldn’t be surprised if the Reserve Bank cuts rates by 0.5% tomorrow.

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Motley Fool writer/analyst Mike King doesn’t own shares in any companies mentioned.

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