Australia Faces Growing Pressure to Cut Rates Tuesday

The Australian central bank which meets on Tuesday is likely to resume its rate cutting cycle given lower commodity prices, a resilient Aussie dollar and weakening growth momentum, economists told CNBC.

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“The strong Australian dollar at a time when commodity prices are well of their highs presents a concern for the Reserve Bank of Australia (RBA) as it means that monetary conditions are tighter than they should be. The best way to reverse this is to cut interest rates,” Shane Oliver, head of investment strategy and chief economist at AMP Capital told CNBC.

Oliver forecasts the central bank will cut rates by 75 basis points over the next six months, starting with a 25 basis cut at the upcoming policy meeting.

The RBA has cut interest rates by 125 basis points since November 2011 to 3.5 percent in June - its lowest level since late 2009.

According to the interest rate futures market, there is a two-in-three chance that the RBA will cut interest rates by 25 basis points to 3.25 percent on Tuesday.

Weaker commodity prices without the depreciation of the Aussie dollar hurts the income of mining companies, whose products are largely priced in U.S. dollars, resulting in weaker national income growth.

Iron ore and coal prices, which account for nearly one-third of Australia’s exports, have been under significant pressure this year on slowing demand from major consumer China. The Aussie dollar, meantime, has remained resilient, rising 1 percent against the greenback in the last three months.  

With inflation well under control, there is plenty of scope for the central bank to cut rates, Oliver added. While inflation edged up to 2.4 percent in September from 2.2 percent in the previous month, according to a private inflation gauge, it remains within the RBA's long-term target band of 2 to 3 percent.

Deteriorating economic indicators, together with concerns over slowing China demand could also influence RBA's decision to cut rates, say economists. Latest data including retail sales, building approvals and private sector credit growth have pointed to slowing economic momentum in the country. The country’s gross domestic product (GDP) rose 0.6 percent in the second quarter, moderating from 1.4 percent in the previous quarter.

While the unemployment rate unexpectedly fell to 5.1 percent in August, the Australia and New Zealand Banking Group (ANZ) said the labor market is also a cause for concern for the central bank.

“We expect the unemployment rate to drift higher as slower national income growth squeezes business profitability, impedes hiring and results in tighter fiscal policy. The RBA needs to ease monetary policy further, starting Tuesday,” the bank said in a note.

Falling job advertisements and job cuts in the mining and resources sector – previously the mainstay of employment growth -  have signaled some easing in the labor market.

ANZ, which expects the RBA to deliver a 25 basis point rate cut on Tuesday, also says the central bank won’t stop there. It expects another 25 basis point rate cut in November as well.

“The RBA needs to ensure that other weaker sectors of the economy, like residential and non-residential construction, are strengthening in late 2013 and 2014 as the mining investment boom winds back,” the bank said.

Paul Bloxham, the chief economist for Australia and New Zealand at HSBC, however, believes it is a close call on whether the RBA will ease policy or not.

“We don’t think the hurdle has been met for a cut. China’s PMI (Purchasing Managers’ Index) was stable, commodity prices bounced back a little and QE3 (third round of quantitative easing by the Fed) has removed some of the downside risk of a sharper U.S. slowing,” he said.

Assuming inflation is contained and economic momentum in the mainland continues to stall, the RBA will cut rates in November, Bloxham added.

By CNBC's Ansuya Harjani