The only way is down for interest rates

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All that stands between lower interest rates come the next Reserve Bank Board meeting on August 6, is next week’s consumer price index report and the Australian dollar. If inflation remains low and the Australian dollar does not drop a lot further – say to the mid-US80c level – the RBA may well cut rates again.

But why?

Despite the tentative signs of improvement in the housing sector, the upturn still remains quite gradual. Neither investors, first homebuyers or existing owners seeking to move, are rushing back to the market – in large part because overall household debt levels are already quite high. High land and development costs are also holding back new activity.

In turn, that means the upturn in house prices has been modest to date, as has the lift in demand for new homes.

Only this week we learnt that residential dwelling commencements fell 5.5% in the March quarter, though are still up almost 13% on year ago levels. Most of this activity, however, is in apartments – underpinned by investor demand – rather than stand-alone homes, which is holding back the amount of new work each new commencement represents. Not helped by an office property glut, a weak manufacturing sector and a peak in mining investment, non-residential building commencements are even weaker – slumping 18% last quarter to be 20% below year-ago levels.

More broadly, the National Australia Bank business conditions index slumped back in June to be well below long-run average levels and the unemployment rate ticked up to 5.7%. Labour hiring intentions remain subdued, suggesting a further rise in the rate of unemployment is likely.

All up, the run of recent data confirms that the economy remains stuck at a below-trend pace of economic growth, even with mining investment at record highs as a percent of the economy.

Meanwhile, the outlook for China is also more cautious: the economy continues to slow as policy makers battle to keep a lid on strong credit growth spilling out of the less regulated parts of the financial system. Chinese economic growth slowed to 7.5% in the June quarter, and there’s growing speculation that growth will slow to 7% by the end of the year. That’s not great news for Australian coal and iron ore prices and could encourage miners to cut back their investment plans even further. As it is, mining investment is levelling out at a high level, but will start falling sharply by late next year.

Keep calm

Of course, there’s no need to panic – just yet. The Australian dollar has fallen in recent months, which will provide some relief to trade-exposed sectors, including our miners. And the $A seems likely to fall further, especially if the United States Federal Reserve acts to tighten liquidity later this year. Canberra’s fiscal policy was also sharply restrictive last financial year, but will have a more neutral impact on the economy this year. Business and consumer confidence could lift once uncertainties associated with the looming Federal election are out of the way.

But most importantly, the official cash rate is still at 2.75% – and could be cut a lot further if need be. As it stands, the RBA has indicated it is prepared to cut interest rates again to avoid an untoward rise in unemployment – provided it can be reasonably confident that inflation over the next few years is unlikely to push beyond its 2% to 3% target band. While the recent decline in the $A will eventually add to import prices, the soft economy, subdued wage growth and intense retail sector competition are acting in the opposite direction.

Based on its latest forecasts, the RBA anticipates that year-ended underlying inflation will edge down to 2.25% in next week’s June quarter CPI report. If that proves right, and especially if this reflects softness in domestic price pressures rather than the ongoing lagged effect of past exchange rate strength on import prices – the way could be clear for lower interest rates in early August.

Important: This content has been prepared without taking account of the objectives, financial situation or needs of any particular individual. It does not constitute formal advice. Consider the appropriateness of the information in regards to your circumstances.

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