Why the RBA will cut interest rates again

Credit: Michael Ilyine

The Reserve Bank of Australia (RBA) looks highly likely to cut the official cash rate again later this year after the central bank lowered its inflation forecasts.

In its recently released Statement of Monetary Policy, the RBA lowered its forecast for underlying inflation to between 1 and 2% for 2016, from 2 to 3%. It’s a problem a number of major advanced economies are experiencing including the US, Japan and Europe.

Inflation in Australia in March was lower than expected, forcing the RBA to cut the official cash rate from 2% to 1.75%. The Bank says various measures suggest underlying inflation was about 1.5% over the 12 months to March 2016.

Underlying inflation May 2016

Source: RBA & ABS

The RBA is tasked with trying to keep inflation in a range of between 2 and 3%, and it makes changes to the official cash rate to move inflation higher or lower as needed. Obviously, inflation of 1.5% is below the band, so a rate cut was required.

The central bank says there has been broad-based weakness in domestic cost pressures, with lower than expected growth in labour costs, in addition to heightened retail competition, a moderation in conditions in housing rental and construction markets and declines in the cost of some business inputs such as fuel and utilities.

The bank says it is possible that domestic costs pressures may weaken further, and inflation may not pick up as expected. That more than likely means more rate cuts, as the central bank tries to get inflation moving higher and back into its band of between 2 and 3%.

The RBA also took account of developments in the housing market, noting the effects of supervisory measure to strengthen lending standards, the recent easing in housing credit growth and the abatement of strong price pressures.

The big four banks Australia and New Zealand Banking Group (ASX: ANZ), Commonwealth Bank of Australia (ASX: CBA), National Australia Bank Ltd (ASX: NAB) and Westpac Banking Corp (ASX: WBC) have not only tightened lending to local investors, but have also virtually stopped lending to foreign property buyers – the major buyers of brand new apartments being constructed in Australia.

Foolish takeaway

We may not see negative interest rates in Australia – unlike Europe – but it certainly appears that we should get ready for more rate cuts. That’s good news for sharemarket investors, but awful news for those investors who prefer to keep their cash in term deposits.

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Motley Fool writer/analyst Mike King doesn't own shares in any companies mentioned. You can follow Mike on Twitter @TMFKinga

The Motley Fool Australia has no position in any of the stocks mentioned. We Fools may not all hold the same opinions, but we all believe that considering a diverse range of insights makes us better investors. The Motley Fool has a disclosure policy. This article contains general investment advice only (under AFSL 400691). Authorised by Bruce Jackson.

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