The Economy: Rate Cut Looms

Interest rates will fall next week after the lowest inflation figures for some time in the March quarter took the market by surprise.

As a result, yields on government bonds fell, hitting 3.648% for the 10 year security, a 61 year low.

And the Aussie dollar fell half a cent to below $US1.03 in local trading Tuesday, only to regain the loss and end around $US1.0350 in trading yesterday and overnight.

The 0.1% rise in the CPI slashed the annual rate to 1.6% for the quarter, down from 3.1% for all of 2011.

The Reserve Bank's core inflation measures were also weaker than expected running around 0.35% in the quarter and 2.15% year-on-year (averaging the trimmed mean and median measures).

The upshot is that the RBA's board next week will lop 0.25% off the cash rate to 4%, with some economists and writers claiming a 0.50% cut is justified.

But that could be seen as a sign of panic from the central bank, although some economists reckon a cut of that size will be needed to offset expected attempts from the banks to grab some of the cut to restore profit margins.

Scott Haslem, UBS chief economist said: ''We're looking for 50 basis points over coming months and we're forecasting a rate cut in May and a follow-up cut in June''.

Paul Bloxham, HSBC's chief economist in Australia, agreed. ''Talk may now be of whether it's a 25 basis points or 50 basis points cut next week.

"We are firmly in the 25 basis points camp, as we think any more would frighten the horses, suggesting conditions are much weaker than the RBA expected.''

Bill Evans, Westpac's chief economist, who has been urging rate cuts for months now, claimed the CPI outcome appeared to have caught the Reserve Bank out.

"It means their assessment of the economy was a little optimistic, and that growth is below trend. We expect there will be another cut in June as well, so two consecutive cuts in May and June [of 25 basis points each."

And the NAB's chief economist, Alan Oster, said in a statement the result had changed his mind about whether the bank would need to cut more than once.

"We previously thought the bank wouldn't go again, but now we think it will. The timing is difficult, but we've stuck [the second cut] in June, on the basis that in the near term we see the economy softish, we see unemployment edging up a little bit and we see no inflation."

All these economists and others missed the weak CPI. The average forecast was 0.5% or 0.6%, depending on which surveys (AAP or Bloomberg). Some earlier estimates were around 0.7%.

Besides interest rates we should keep a close eye on the value of the dollar.

There's now a chance the dollar will fall to parity in the next month or so, which will take a small amount of pressure off some sectors of the economy.

The big influence in consumer prices of the past year was seen in this result in the unwinding of the impact of higher fruit and veg prices after last year -- which also saw a flat CPI result for the December quarter.

Remember how Cyclone Yasi damaged the north Queensland banana crop and sent prices surging higher, and how the Queensland floods also sent vegetable prices rising?

What goes up must, in this case, come down. Fruit was down 30% in the quarter and those bananas 60%.

But the most significant rises pharmaceutical and education costs, both of which are highly cyclical (annual PBS changes, back to school costs) and always happen at the start of each year.

That's why the seasonally adjusted CPI was actually slightly negative and a low result across the board and in most parts of the country, aided by the continuing discounting in many parts of retailing (another Myer or David Jones sale, anyone?).

But it's still a genuinely low result, and one that reflects the actual cost of living for families. The cost of overseas travel might have fallen, but so did clothing and footwear, as well as household goods.

Darwin and Hobart saw the biggest CPI rises, then Brisbane and Perth. Sydney was low and Melbourne flat, Adelaide negative.

Judging by the tone of the minutes from the April RBA board meeting, there might have been some hesitation about cutting rates further after the May meeting.

But the CPI outcome means all the main measures of inflation are now at the bottom of the central bank's 2% to 3% inflation target range, allowing more cuts later in the year if the political problems in Europe re-ignite strains in the financial system and see the eurozone economies fall deeper into recession.

Since late last year, the RBA has indicated that Europe is the biggest external threat to the Australian economy and even though fears had eased in the first quarter thanks to the European Central Bank's two rounds of three-year loans to banks across Europe.

But they never fully went away. Now the austerity plans for Europe, devised by Germany, the Netherlands, France and Finland are being rejected by voters and hard right and left wing politicians in France and the Netherlands.

So watch Europe, there might be more in what happens there for the future path of Australian interest rates than what happens in our economy in the next few months.