The Reserve Bank of Australia has a monetary policy announcement this evening and based on recent developments inside and outside of Australia, there’s a reasonable possibility that the central bank could set the stage to ease again. One of the biggest stories over the past few weeks has been the drop in iron ore prices. Over the past 3 months, the price of iron ore has fallen more than 30 percent to a 3 year low and unfortunately iron ore is very important to Australia, accounting for more than 20 percent of total export values last year. The decline in iron prices has been caused by slower growth in China, which is a double blow for Australia because China takes 25 percent of Australia’s export of which 60 percent is iron ore.

Australia Sensitive to Troubles Abroad

Having already lowered interest rates by 75bp this year to 3.5 percent, the RBA has provided significant support to their economy. When they last met in early August, the RBA sounded very comfortable with the current level of monetary policy. While the central bank governor felt that global growth had softened in recent months, he said domestic conditions appeared to be strong, the financial markets have responded positively to progress in Europe and most importantly, China’s growth did not appear to be slowing further. Unfortunately things are beginning to change and the RBA may need to set the stage to ease monetary policy again before the end of the year. In Europe, Catalonia’s request for a bailout from the government of Spain and the liquidity boost into Bankia, the country’s fourth largest bank means that uncertainty has returned. Chinese economic data also worsened with manufacturing activity hitting its lowest level since March 2009 according to the HSBC Manufacturing PMI numbers released yesterday evening. Trade activity deteriorated significantly with export growth in China rising a mere 1 percent in July. The country is experiencing its weakest expansion in 13 years which spells big trouble for Australia because China their largest trading partner. Throughout the financial crisis, Australia has avoided recession thanks to growth in China but if their Asian partner slows at a time when Europe and the U.S. are experiencing anemic growth, the strength in domestic demand could fizzle quickly.

Domestic Conditions Have Been Softening

One of the areas of the economy that the RBA has felt most optimistic about is the labor market and since the last monetary policy meeting on August 7th, we have seen job growth improve and the unemployment rate drop to 5.2 from 5.3 percent. Yet this rebound in the labor market has not translated into stronger consumer confidence or higher retail sales. According to the latest reports, retail sales fell 0.8 percent in July while consumer confidence dropped 2.5 percent. Housing market activity has been mixed with new home sales and building approvals declining but home loans increasing. The following table illustrates how economic data has fared since the last monetary policy announcement.

While manufacturing activity contracted at a slower pace in August (the PMI index rose 5 points to 45.3), the drop in iron ore prices poses a major threat to companies such as BHP Billiton, Rio Tinto, and Fortescue Metals Group. Analysts predict that if the iron ore price stayed at current levels, BHP’s earnings would be 23 per cent lower than expected, Rio’s 41 per cent lower, and Fortescue would fail to make a profit. Weaker profitability for some of Australia’s most important companies could temper the RBA’s rosy outlook. While we do not expect another rate cut from the central bank on Tuesday, we anticipate less optimism and greater caution, which could take the AUD/USD below 1.02.

The Risks to Our RBA View

With this in mind, there is still the possibility of a neutral statement from the central bank as it would not be the first time the RBA has turned a blind eye to weaker data. The central bank could take the view that their recent rate cuts haven’t fully filtered through the economy and should continue to lend support for business and consumer demand. Also, the possibility of easier monetary policy from the European Central Bank or the Federal Reserve later this month could also encourage the RBA to wait another month before setting the stage for further rate cuts. If there is one thing the RBA has, it’s the luxury of time because they have already eased aggressively this year. The recent decline in the Australian dollar exchange rate from 1.06 to 1.0250 gives the central bank additional breathing room. If the RBA indicates that they remain comfortable with the current level of monetary policy, the Australian dollar could rise back above 1.0350.

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