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Aon Retirement and Investment Blog

Reserve Bank of Australia Interest Rate Cut

On May 3rd, the Reserve Bank of Australia (RBA) cut the cash rate by 25 basis points to 1.75%, a record low, marking the eleventh reduction without an increase in the cash rate since 2011.
Although the market had been predicting a further interest rate cut after May, views were split about a rate cut this meeting. A Bloomberg poll states that the majority of economists expected no change. The Australian dollar fell by 2% against the US dollar, as seen in the chart below, but the daily move was smaller on a trade weighted basis.
Markets adjusted to lower inflation but were still caught out by the rate cut

The RBA clearly pointed its finger at the more benign inflation outlook as the main driver for the move. This makes sense given that, only a week earlier, annual headline Australian inflation fell to 1.3% (from 1.7% a quarter earlier, see chart below), while the underlying inflation rate was the weakest since records began.

So what is the outlook for rates now? The decision by the RBA to hone in on inflation as the all-important factor in determining appropriate monetary policy is a deliberate and thoughtful one. In a time when inflation is likely to stay muted, it allows the RBA flexibility to cut interest rates again. Why is the inflation outlook so muted? The Australian dollar’s broad declining trend has paused for thought, which means that the benefit to the Australian economy from higher imported inflation from abroad has limits (i.e., a low AUD increases the price of imports, and potentially reduces inflation in the trading partner’s economy). Growth in domestic demand looks to be a more promising avenue, but the RBA itself has implied that the strong growth seen recently will prove transient, and that more moderate growth can be expected, citing subdued labour cost growth as a drag. Indeed, markets are pricing in another cut in September this year, and we think that looks reasonable.
Our medium term views are largely unaffected; we still see modest weakness ahead for the Australian dollar, helped by continuing easy monetary policy. Moreover, the recent commodity driven rally in the Australian dollar of c.5% makes it a good time to trim currency hedges. Also underpinning this view is our outlook on commodities, whereby we think fundamentals are still weak and therefore the picture is one of consolidation rather than sustained rally. Furthermore, sustained US dollar weakness (the US dollar is down 7.5% year-to-date on a trade weighted basis) looks ripe for a reversal. Then again, the new fiscal stimulus package, also announced May 3rd, detracts slightly from the argument in favour of Australian dollar depreciation. On the equity side, although looser monetary policy clearly helps, stocks are likely to remain challenged due to lofty valuations.
Josh Cooper is an asset allocation specialist in Aon Hewitt’s Global Asset Allocation Team in London.

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