Special Report- Is it time for an interest rate cut for Australia?

As the market focuses on the Reserve Bank of Australia (RBA) interest rate decision, the question on investors’ minds is whether the central bank is going to change its monetary policy. RBA will decide on interest rates on Tuesday May 1 at 04:30 GMT.

As inflation softens, pressure for RBA to ease

Investors have strong reasons to argue for a possible interest rate cut below the current 4.25% level. Consumer Price Index (CPI) revealed a softer than expected figure of 0.1% lower than the 0.7% gain expected. The yearly inflation of just 1.6% is outside RBA’s 2-3% management bracket putting more pressure on the central bank to ease its monetary policy. The economic relationship of Australia and China further intensifies the need to ease further. China’s government has lowered its growth forecasts to 7.5% in 2012 down from last year’s 8%. China is Australia’s largest trade partner and a slowdown in China’s economy may impact demand for Australia’s commodities.

But what is the impact of lower interest rates on a currency? Lower interest rates for a country mean lower rates of return for holding its currency, which leads to lower demand, and thus depreciation of its value. The Australian dollar strengthened to a 2-week high against the US dollar but the weakness of the greenback is fuelling its rise.

What did RBA say?

During its last monetary policy meeting, RBA decided to keep rates at 4.25% for the third time in a row after easing its cash rate by 25 basis points in both November and December. Central bank’s policymakers said in their accompanying statement that the Australian economy has an expected pace of growth that will be lower than earlier estimated and that the next inflation report will provide a clear picture before easing its monetary policy further. RBA governor Glenn Stevens has indicated a cut in rates was likely if inflation had moderated further. Considering RBA’s statement and the weaker than expected inflation figures, investors are expecting rates to decrease at the next policy meeting.

The scenarios

It is not an easy decision for the central bank. Recent economic data was disappointing; triggering the question of whether Australia’s pace of growth is slowing. A weak housing market, a soft inflation and a slowdown in China, increases the possibility that RBA may need to act on supporting growth. Also, Eurozone debt problems and slow economic recovery in the US weigh on sentiment about the global economic outlook. What is certain is that volatility should surge, leading to large price swings in the Aussie crosses.

A scenario of 25 basis points cut in interest rates may be already priced in market expectations and a limited reaction is expected. In the scenario where a 50 basis points interest rate cut occurs, this may surprise investors and put increased pressure on the Aussie, causing it to seek new lows. Investors’ real focus will be on the accompanying statement where policymakers will speak about the Australian economy, inflation forecasts and any signs for further interest rate cuts.

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