Persistently low inflation is creating a headache for the Reserve Bank of Australia, especially given that it is reluctant to make further cuts to interest rates, according to HSBC.
In its update for the first quarter of 2016, HSBC noted that growth is finally lifting as the Australian economy rebalances away from mining – but inflation is still low.
"The extended period of below-trend growth following the mining boom is weighing on local inflation," wrote HSBC Australia chief economist Paul Bloxham and fellow economist Daniel Smith.
"Growth has now been below trend for three years and the unemployment rate is well above its full employment level of around five to 5.25 per cent," said the HSBC report.
The challenge for the RBA is that inflation has fallen too close to the bottom end of its two to three per cent target band, and more growth may be needed to keep it on target, said the report.
"However, with interest rates already at record lows and having boosted asset prices significantly, the RBA is concerned that further cuts could threaten financial stability," said HSBC.
"An alternative strategy may be to encourage the Australian dollar lower, but this clearly relies on offshore developments as much as domestic ones," it said.
With underlying inflation threatening to fall below the target band in year-on-year terms, HSBC has predicted a 25 basis point cut to the official cash rate in the first half of 2016.
"However, there is significant uncertainty about this, particularly given the RBA's considerable reluctance to make further cuts," said HSBC.
"The Australian government has scope to support growth with fiscal policy although, so far, it has been unwilling to consider this as an option," it said.
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