No point dithering on rates

PORTFOLIO POINT: The Reserve Bank will make further cuts to the cash rate in 2012, and another 75 basis points seems plausible.

The RBA cut its cash rate target by 50 basis points to 3.75%. Morgan Stanley (and consensus) had expected a 25bp cut. It seems the key to the larger-than-expected cut was the larger-than-expected decline in inflation, reported last week.

The RBA also acknowledged that economic conditions have been "somewhat" weaker than expected. This leg of the mining boom is being driven by investment spending (2003-08 was driven by the rising terms of trade). GDP growth outside of investment spending has been running below 1% for the past year (Exhibit 1).

Source: ABS, Morgan Stanley Research

The two tracks of the economy are much more divergent now than in 2003-08, because the principal channels that saw mining-related strength flow to the non-mining part of the economy are not working. In particular, the federal government was able to fund tax cuts and spending increases through 2003-08; now the federal government is tightening fiscal policy. In addition, relatively easy credit conditions saw significant house price gains; now house prices are falling.

We expect more rate cuts; another 75bp by year-end seems plausible. Further easing will be required, in our view, to counteract fiscal tightening and the still-high Australian dollar (Exhibit 2). In addition, the 50bp cut seems tacitly to acknowledge that not all the cash rate reduction will be passed on to borrowers by the banks.

Source: JP Morgan, Morgan Stanley Research

Finally, it's not clear that lower rates will have as powerful second-round effects now as they did in 2008-09. That easing, combined with the government's first home-buyers grant, saw a 19% lift in house prices over the year to March 2010. We doubt that that will be repeated, although lower rates reduce some of the downside risks to house prices.

Gerard Minack is head of global developed market strategy at Morgan Stanley.