A question of RBA firepower
The Reserve Bank's decision is less straightforward than market pricing might suggest, complicated by banks' likelihood to retain part of any cut and a desire to hold arsenal in case of a European implosion.
The market has been pricing in the 100 per cent probability of a 25 basis point cut to the cash rate tomorrow and something approaching an 80 per cent probability of a 50 basis point reduction. The turmoil in markets sparked by poor US economic statistics on Friday can only have strengthened the belief that the RBA will act.
In fact the market has priced in a whole series of rate cuts, expecting the cash rate to tumble from 3.75 per cent today to 2.25 per cent by December. That may well eventuate, although it would be a signal of real distress within the global and domestic economy if it did.
There are a range of factors that will give the RBA board pause for serious thought about whether or not to follow May’s 50 basis point rate reduction with a further reduction.
One of the more obvious is that it knows from the May experience, when the banks declined to pass through the full 50 basis points (which the RBA anticipated and built into the decision to cut by 50 basis points rather than its conventional 25 basis points) and from its continuing engagement with the major banks that they would almost certainly again retain a proportion of any official rate cut.
The impact of a 25 basis point reduction in the cash rate would be muted if the banks, still experiencing pressure on their net interest margins from the competition for deposits, hung onto five or ten basis points. That means the RBA, if it wants to generate some meaningful stimulus, would need to seriously contemplate another 50 basis point cut.
With the cash rate at 3.75 per cent, reducing rates by half a percentage point at a time erodes the potential for the RBA to take really decisive action if the situation demands it, as it may well do.
Europe is on the verge of imploding, with the new election in Greece still two weeks away, the US has slowed again and even China is starting to feel the effects of the recessed global conditions and its own attempt to rein in inflation last year.
If the Europeans can’t devise some mechanism for stabilising their dangerously unstable fiscal positions and recapitalise their dangerously under-capitalised banks then the RBA, and the Gillard government, are going to need all the monetary and fiscal firepower available to them.
During the worst of the first phase of the global financial crisis the RBA cut rates six times, by a total of 300 basis points, between September 2008 and April 2009. The Rudd government also doused the economy with cash.
If Europe implodes then the stretched state of government finances in Europe and the US, and the somewhat more limited ability of China to repeat its massive stimulus strategy, may dictate an even stronger stimulatory response here. The RBA may want to preserve its firepower for when it is really needed.
The board would also, no doubt, consider whether there has been sufficient time to determine whether last month’s rate cut has had any positive impact – monetary policy usually takes some time to have an effect – and would be conscious that while the most recent federal government cash handouts are flowing to households, the full impact of the $2.5 billion in school kinds bonuses and the pre-emptive compensation for the carbon tax has yet to be felt. (Has there ever been worse timing for the introduction of a great big new tax?)
It would also be mindful that the settings for a key influence over the recessed conditions in the non-resource states are changing.
When the Reserve Bank met last month the Australian dollar, while trading a long way short of the high of $US1.10 it reached in the middle of last year, was still comfortably above parity at $US1.02. Today it slipped below 97 US cents. That will relieve some of the pressures on local companies and be mildly stimulatory, although the currency is still trading way above historical levels.
There is no doubt that the non-resource sectors of the economy are struggling. The retail and manufacturing sectors are being ground down by the erosion of consumer confidence and the significant household deleveraging that is occurring. The job losses and corporate failures are mounting and house prices continue to slide. The investment boom in the resources sector continues – but the pipeline of projects yet to get underway is shrinking rapidly.
There has been a massive loss of confidence that will be further impacted by the fall in the Australian sharemarket below 4000 points today and which one suspects won’t be turned around, whatever the RBA might do, unless and until federal parliament is functioning more conventionally and Europe has been stabilised.
The RBA board will have to weigh up complex competing arguments as to whether or not to cut rates again and, if so, by how much. It will have to think its way through likely developments, and their likely timing, in Europe and the US and how it might be forced to respond. Despite the market’s certainty, it is most unlikely to be a straightforward decision.