The Reserve Bank Board meets on Tuesday next week, with the result of the meeting announced at 2.30pm.
Current market pricing is for the risk free rate to be 4.08 per cent on December 2, almost 125bps below its current level. A 125bps rate cut would be larger than any move since the Bank started specifying an exact target cash rate on August 2, 1990 when it cut rates from 15 per cent to 14 per cent.
That, of course, was in the depths of the 1990/1991 recession when the unemployment rate stood at 7 per cent (having risen from 5.6 per cent and on its way to 10.9 per cent in December 1992). Since that date there have been 11 moves (in either direction) of 100bps; three of 75bps; eleven of 50bps and twenty two of 25bps. There has never been a 125bps.
The next extraordinary aspect of current market expectations is that of the eleven 100bps moves, ten have been in "safe" territory – that is when the moves have been toward neutral. There was one 100bps tightening when rates were below neutral and nine 100bps cuts when rates were clearly well above neutral.
It would really only be the 100bps tightening in December 1994 from 6.5 per cent to 7.5 per cent when there was a big move to push rates further away from neutral.
Readers will recall that the December 2004 move was at a time when markets expected multiple further moves (even after 275bps of tightening, 3 year bond rates were 120bps above cash) but that large move which pushed rates further away from neutral proved to be enough to sufficiently slow the economy and the next move was actually down in July 1996.
Last week the RBA Governor indicated that the clue in the RBA minutes was indeed accurate. The Bank assessed that "neutral" was 5.25 per cent. So markets are expecting a record move in the direction which is away from neutral, even after rates have already been lowered by 200 bps over the last three months.
During that recession period when the unemployment rate was rising from 5.6 per cent to 10.9 per cent, rates took nearly two years to get back to neutral and there was no four month period when rate cuts totalled more than 200 bps – let alone the 325 bps now anticipated by the markets.
So the moves anticipated by the market are way too ambitious. The argument that the December move has to cover two months (because there is no scheduled meeting in January) is naive. As we have seen on numerous occasions with the Fed a board meeting can be convened with a phone hook up if extraordinary circumstances so warrant.
Rates were cut in both January 1990 and January 1992. We also know that the surprisingly large moves in October and November were not the original recommendations to the Board. Decisions were made on the day of the Board meeting to increase the cut from the original 50bps (to 100bps in October) and 50bps (to 75bps in November). The decisions appear to have been made following exceptionally poor news out of the US over the weekend (eg the Dow fell by around 10 per cent during the period around the October meeting).
Concern with not giving the market what it wants seems also to be limited. In both October and November the market was not expecting the result delivered by the Bank. In November there was the added risk of surprising the market when liquidity was limited due to a holiday in Melbourne.
We are not suggesting that there will be no move at all. Clearly the Bank has the intention to quickly move rates lower so that monetary policy is helping rather than hindering the economy. We assessed neutral as 4.5 per cent but cannot deny the clarity of the Governor's observation that neutral is 5.25 per cent. We support an aggressive move of 75bps with an outside chance of 100bps but cannot manage the stretch to 125bps.
Since the last Board meeting on November 4 global economic conditions have deteriorated. Westpac's Commodity Price Index (WCFI) has fallen by 8 per cent – but it has actually recovered by 6 per cent in recent days. But prior to the November Board meeting (75bps cut) the Index had fallen 17 per cent; prior to the October meeting (100bps cut) it had fallen by 17 per cent. Since the last Board meeting the Dow has fallen by 6 per cent – a similar fall to the pre November meeting and around half (13 per cent) the fall prior to the October meeting.
To be sure US data has deteriorated rapidly. US 3 year bond rates have fallen around 80bps since the last Board meeting whereas the falls were around 55bps prior to both the October and November meetings.
The Bank will also be aware of the risk of a negative growth quarter in September. Our current forecast for September quarter GDP, which will be announced at 11.30am the day after the Board meeting, is for growth of just 0.1 per cent with the distinct possibility of a negative for non-farm GDP. Prospects for the December and March quarters are brighter as the economy benefits from the $10.4bn fiscal stimulus. However the Board will be aware of the response to the last negative growth result in December quarter 2000 when consumer sentiment fell 13.2 per cent in the wake of intense media speculation about a recession.
On the local front there have been some encouraging economic signs amongst all the gloom – petrol prices have fallen from $1.38 per litre to around $1.00 in many places (compared to falls of only 12 cents before November meeting and no falls prior to the October meeting). Consumer Sentiment rose by 4 per cent; mortgage applications with the major banks have responded very positively to the increase in the First Home Owners grant and the rate cuts; jobs growth was strong (up 35,000) in October; construction spending grew by 4.4 per cent in the third quarter; the collapse in credit growth seems to be stabilising (three month annualised credit growth in the September quarter was 7.5 per cent up from 6 per cent in the June quarter); new home sales increased by 6.7 per cent in October and the government is set to launch its $10.4bn fiscal stimulus package on December 8.
Thursday's survey of investment plans still points to expectations of a 24 per cent increase in nominal business investment in 2008/09. When we saw the last estimate of a 29 per cent increase, in the August Survey, we expected a much sharper reduction in investment plans for the November Survey. Certainly the 2009/10 expectations are likely to be down sharply when we get the first estimate in February but this survey is at least indicating that business investment can be relied upon to support growth in the first half of 2009 until the housing and public sector infrastructure investment cycles start to ramp up.
Also, don't lose sight of how expansionary policy is likely to become. Based on our forecasts of the cash rate by mid 2009 (down to 3.5 per cent compared to current market expectations of 2.75 per cent) and the RBA's forecast of underlying inflation, the real cash rate will be significantly lower than at any time over the last 20 years. This provides one measure of the extraordinarily stimulative stance being taken by the monetary authorities – in light of this, we query whether the Bank would be comfortable to push the cash rate down to 2.75 per cent as currently favoured by the market.
Real fixed rates also look to be extraordinarily expansionary. These fixed rates also encompass current market price expectations and emphasise just how expansionary policy is set to become even if the more conservative Westpac forecasts prove to be correct.
We are also encouraged that our forecast that the unemployment rate will peak at around 6½ per cent is not too "rosy ". Recall that Australian workers have been incredibly disciplined through this period of higher than expected inflation. Real wages have been falling sharply. That is apparent in the slowdown in consumer spending but also bolsters employment. The inevitable slowdown in the demand for labour will be partly cushioned by the current fall in real wages as workers price their services competitively. We are not moving our target 3.5 per cent low point for the cash rate in this cycle and that includes a 75bps cut on December 2.
Markets look to have overreached and are setting themselves up for yet another surprise – this time in the opposite direction!
Bill Evans, is Westpac's managing director economics & research