Since the last board meeting there have been a number of global developments with local relevance. The most ‎significant has been the continued dramatic fall in global oil prices, which are now 60% lower than in the middle of last year. The fall in oil prices reflects both weaker global demand and a boost to supply, and it is still too early to tell which of these forces is the most significant. Markets have generally interpreted the fall as at least partly due to weaker demand, with global bond yields falling, as inflation is expected to be lower. Consumer price inflation is falling across many countries, with a number of central banks already responding by lowering interest rates. Europe has also seen significant financial developments in the past month, with the ECB beginning a sovereign bond purchasing programme, the Swiss abandoning their exchange rate ceiling and the election of a new government in Greece once again raising concerns about the possibility of that country exiting the Eurozone. This has generally seen a flight to quality assets, further pushing government bond yields lower in a number of countries.

For Australia, the economic indicators have continued to show signs that low interest rates are supporting a pick up in activity. Housing prices and construction activity have continued to pick up and retail sales have been growing solidly. Surveys suggest business conditions have generally been trending higher, although business confidence remains weak. Working in the other direction, mining investment is falling, although this is being largely offset by a ramp up in resources exports, as new capacity comes on-line. The net effect of these divergent forces on local demand is difficult to assess, but the solid underlying inflation numbers for the fourth quarter of 2014 (0.7% q-o-q) give some indication that demand is holding up. The 8% fall in the AUD since the last board meeting should further help to support the rebalancing of growth and local demand.

The fall in oil prices, combined with the repeal of the carbon tax last year, has seen headline CPI inflation fall below the bottom edge of the target band (1.7%), and lower petrol prices likely to see it fall further in Q1. However, for the setting of monetary policy it is the outlook for underlying inflation and inflation expectations that matter most. In principle, the fall in oil prices should be a net positive for local growth, as Australia is a net petroleum importer, and lower petrol prices should boost household disposable incomes and business profits. Although there is some scope to consider cutting the cash rate in the short run, as headline inflation will be lower than previously expected due to lower oil prices, it is the medium-term outlook for inflation that matters most. In the medium-term, the effect of lower oil prices is somewhat ambiguous, but I view it as more likely to be an upside risk than downside risk to underlying inflation, as I expect the boost to demand from lower petrol prices to more than offset the negative impact on the domestic economy of lower oil prices on energy exporters. In addition, there is the ongoing risk that further interest rate cuts could risk over-inflating an already booming housing market. I recommend that the cash rate is left unchanged.