Could interest rates be cut to 1%, or lower?

If the Reserve Bank of Australia is correct with the forecasts for inflation that were published in its Statement on Monetary Policy, official interest rates should and will be cut to 1 per cent or even less by the end of the year.

That’s right, official interest rates could be approaching zero if, and that’s a big if, the RBA’s inflation forecasts are correct.

The RBA produced its latest quarterly update for the economy on Friday. The highlight was its forecast for inflation to hover between 1.5 and 2.5 per cent right through to the middle of 2018.

With the risks to those forecasts symmetrical, that is there is a 50 per cent chance that inflation will spend the next two years below 2 per cent, which is below the bottom of the RBA’s target range.

Also read: RBA cuts cash rate to boost inflation

There is little hint in the RBA forecasts that inflation will move to the middle of the 2 to 3 per cent target band for many years.

Of course, the RBA may be wrong. It often is. What is odd is that it seems to have been swayed by a single, unexpectedly low, inflation result for the March quarter and extrapolated that as the likely inflation momentum for the next few years.

This could be a mistake which is why it is highly likely that it will wait to see the next inflation data in late July before deciding whether it needs to cut interest rates or not.

While inflation is very low at the moment, not just here in Australia but around the world, there is a hint that global inflation is starting to turn higher.

Inflation in the US, China and Europe is higher today than just a few months ago, commodity prices are generally higher which if sustained, would feed into broader inflation measures over the medium term.

Some of the reasons for the very low March quarter inflation result last week will not be repeated in subsequent quarters and could even swing to the point that we see a surprisingly high inflation results in the June and September quarters.

In the March quarter, fruit prices fell 11.1 per cent, clothing and footwear prices fell 2.6 per cent and petrol prices fell 10.0 per cent. These three items alone subtracted 0.5 percentage points from the CPI.

Had the price of these items been flat, inflation would have been 0.3 per cent.

If the price of fruit, clothing and petrol rebounds in coming quarters, which seems likely especially for petrol as the global oil price rise, all of a sudden the quarterly inflation readings will be 0.7, 0.8 or 0.9 per cent and annual inflation will rapidly be on track to get back to 2.5 to 3 per cent.

Also read: Relief all round at the RBA

This is where the RBA’s new forecasts might be wrong.

All of which suggests that the RBA is taking some risk over-egging the importance of the very low inflation result in the March quarter.

It is also important to recall that the interest rate cuts aren’t much to do with a weak economy – because it’s not weak. It’s not because the unemployment rate is rising – it’s actually falling.

All of which suggest the RBA forecasts for inflation could well turn out to be wrong. They probably will.

The forecasts are too low and that because of that, further interest rate cuts are unlikely and inflation will not stay all that low for all that long.

Stephen Koukoulas is a Yahoo7 Finance expert with 

more than 25 years experience as an economist in government, as Global Head of economic and market research, as Chief Economist for two major banks, and as economic advisor to the Prime Minister of Australia.