Will Australia Deliver a Surprise Rate Cut?

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Syndney, Australia

Australia's central bank, which holds its first policy meeting of the year on Tuesday, could use the opportunity to deliver a surprise interest-rate cut to underpin the economy and dent the appeal of the robust Aussie dollar, strategists told CNBC.

The Reserve Bank of Australia (RBA) lowered interest rates by 125 basis points last year, taking its benchmark interest rate to 3 percent, amid a weakening labor market and prices of some key commodities Australia exports.

Its latest move was a quarter-point cut in December and was recent enough for many economists to say the RBA will hold its fire this month. Markets put the chances of a rate cut this week at just 18 percent.

Still, some analysts say that with inflation benign and data still pointing to weakness in some sectors of the economy, further monetary easing should not be ruled out.

"There is more chance of a rate cut on Tuesday than markets are pricing in," said Ray Attrill, co-head of foreign exchange strategy at National Australia Bank in Sydney.

"After the CPI (Consumer Price Index) numbers (released) in January we thought that tilted the balance in favor of a move in February, having previously anticipated a move in March," he said, adding: "Our view is that the Australian economy is much weaker than generally understood."

Australia's consumer price index rose 0.2 percent in the fourth quarter from the previous quarter and compared with a 1.4 percent increase in the third quarter, data released last month showed.

A survey released last week meanwhile showed that the manufacturing sector remains weak. The Australian Industry Group's manufacturing index fell 4.1 points in December to 40.2, well below the 50 level that separates contraction from expansion.

"The possibility of a surprise rate cut seems plausible," Ilya Spivak, currency strategist at Daily FX said in a research note. "Although the international landscape has somewhat improved since December's rate decision, Australia's domestic profile seems to have suffered. Most worryingly, PMI (Purchasing Manager's Index) data point toward accelerating contraction across the industry spectrum and on key activity gauges including output, employment and exports."

Strong Aussie

NAB's Attrill said a strong Australian dollar could be another incentive for the RBA to deliver a surprise rate reduction on Tuesday.

The currency is up about 8 percent against the U.S. dollar from lows hit below the $1 mark in May last year.

(Read More: You Just Can't Keep This Currency Down)

"We see evidence that the economy has been pretty weak and that is because the effects of currency strength is percolating through broad swathes of the Australian economy," he said. "If they do cut, the currency is likely to be one of the key guiding factors and there is an opportunity there for the RBA to give the currency a nudge in the direction it would like to see it go."

Currencies have been in the spotlight with the yen weakening sharply in recent months amid expectations for aggressive monetary easing from Japan, while a rally in the euro is expected to be high on the agenda of the European Central Bank when it meets later in the week.

(Read More: Watch What Central Bankers Say, Not What They Do)

Shane Oliver, head of investment strategy at AMP Capital, said that while he expects the RBA to hold monetary policy steady on Tuesday the decision was too close to call. Oliver said the case for further rate cuts remains strong and expects easing in the months ahead.

That's a view shared by Attril, who believes the RBA will deliver three rates cuts in total this year.

Differing Views

Other analysts, however, believed the easing cycle in Australian monetary policy may well be over for now with signs of weakness in the economy balanced by other positive signs.

For instance, home prices in Australia's major cities rebounded in January, a survey by property consultants RP Data-Rismark showed last week.

"The external story is looking better and if you look at the domestic story, there are some signs that rate cuts are starting to work," said HSBC's chief economist for Australia, Paul Bloxham, referring to signs of a rebound in the U.S. and China – the world's two biggest economies.

HSBC expects Australia's economy to grow just under 3 percent this year.

"So this combination means the RBA will be on hold on Tuesday and in fact we think the RBA is done with rate cuts for this cycle," Bloxham said.

(Read More: Will Lady Luck Return to Australia This Year?)

Thomas Murphy, a managing partner at Family Office Research & Management in Sydney shared the view that the rate cut cycle was nearing an end.

"Australia's economy is going to look better in six months' time than it does now," he told CNBC Asia's "Cash Flow." "There is an expectation in markets that there will be another rate cut (in the coming months) and I think that will be the last one."

- By CNBC's Dhara Ranasinghe;Follow her on Twitter: @DharaCNBC