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Deflation (falling prices or negative inflation) is sometimes confused with recession (or negative growth). The two sometimes go together, but not always – see “So this deflation… is it a good thing or a bad thing?” below.

So Australia has joined the deflation club. The question is, what does this mean for interest rates (and the exchange rate)…

…and is deflation generally a good thing or a bad thing for the economy?

First up, the surprise numbers. Economists expected weak inflation but they didn’t expect the Consumer Price Index to fall over the three months to March 2016.

Falling petrol prices helped it fall 0.2%, taking annual inflation from 1.7% down to 1.3%. This is the first fall since 2008.

cpi

Will interest rates fall?

The Reserve Bank of Australia meets next Tuesday (3rd May) and will undoubtedly consider cutting the cash rate from its current level of 2%.

Traders’ expectations (implied by prices for interest rate futures) indicate about a 50% likelihood of a cut next week (up from only 13% yesterday before the inflation data was released).

Why the RBA will be tempted to cut

  • Annual inflation is now only 1.3% and “core inflation” (which adjusts for volatile items like fuel) came in at 1.55% – way below the bottom of the Reserve Bank of Australia’s target band of 2% – 3%.
  • The numbers indicate a slowing economy, with weak demand and flat wages.
  • The RBA would like to see a lower currency (which would help Australian businesses to compete internationally) and even the current cash rate of 2% is enough to lure money from France and Germany which have 0% official rates, and in the U.K. and the U.S. with their 0.5% official rates.
  • The RBA has been concerned that lower rates might pump more money into the Australian property market – so current weakness in property prices will alleviate those concerns.

Why they might hesitate

  • The cash rate is already low and the RBA are on record as saying that rates are not stopping businesses from investing, and that stimulus should come from other areas (such as the budget).
  • The RBA look at other data suggesting steady (if weak) economic expansion and a relatively healthy jobs market.
  • They generally try to avoid rate moves during elections (but they have done so in the past when they’ve thought it important enough).
  • They will be tempted to wait until after the Budget in order to assess whether it will deliver any stimulus to the economy.

On balance, we think it is likely the RBA will cut the official rate from 2% to 1.75% (if not next week, then in coming months).

And the currency?

The Australian dollar fell about a cent following the release of the inflation data. If the RBA does cut rates by 0.25% next week, the currency market will start thinking about another possible cut to 1.5% keeping downward pressure on the currency. If the RBA leaves rates unchanged, the currency may bounce.

So this deflation… is it a good thing or a bad thing?

No-one likes inflation, surely, so isn’t deflation a good thing? Well, it’s a bit like Cholesterol where there’s ‘good cholesterol’ and ‘bad cholesterol’…

Temporary deflation is good. Lower interest rates will provide relief to mortgage holders and a lower currency will help businesses compete. And with employment reasonably strong (so far), falling prices mean our wages stretch further. Food, clothing, holidays and petrol are all getting cheaper and even rent is growing at the slowest pace in nearly two decades

Long term deflation is bad. Deflation that persists for years (as it has in Japan and in some European countries) is associated with stagnant economic growth because with interest rates at or close to zero, central banks run out of ammunition to stimulate the economy. A little bit of inflation also helps borrowers (helping their assets to increase in value compared with the size of their debt) and enhances flexibility in the labour market. Long term deflation hurts in these areas.

So we’re hoping the March quarter deflation is a temporary thing.

What are your thoughts?

Can the Australian economy keep delivering it’s Goldilocks performance… a taste of welcome price relief but avoiding stagnation?

Join the conversation — leave a comment below and let us know what you’re thoughts are.

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