RBA puts on the brakes
Governor Glenn Stevens has made it clear he plans to slow the pace of rate cuts over the course of the year, but a small cut in March remains likely.
We are still comfortable that the end low point will be 2 per cent but the process of achieving that target will be more drawn out. We now expect a 25 basis point cut in March to be followed by a series of further 25 basis point cuts, with the low point being reached in the third quarter of 2009.
The key observation from Governor's prepared statement and Q&A session that support our forecast is that the Governor talked about being comfortable with easing by more "if needed". Further he noted that markets are pricing in a low point for the cash rate of 2 per cent or 2.25 per cent, and he had no desire to encourage nor discourage that view. Clearly that leaves his options open to eventually reach that level, but he does not necessarily have it in his mind for the near future.
He noted that a point would be reached in the easing cycle when diminishing returns would set in – presumably that refers to the ability of the banks to pass on any rate cuts to private rates, especially mortgage rates. We note the difficulties the banks are likely to face in this process since they have so far not been able to reduce their deposit rates as far as the cash rate or mortgage rates, putting additional pressure on other loan rates. Note however that the 'inertia' in some other loan rates, especially those associated with businesses, would be linked with a higher assessed credit risk and the more general global repricing of risk.
He also invoked a theory he attributed to the previous Governor MacFarlane, who noted that once rates got outside some normal range it was difficult to assess their effects. I have heard that one before with the 'explanation' that if rates get too low households will act as if such low rates cannot be sustained and will therefore 'ignore' the low rates as a signal that it has become even cheaper to borrow. I don't see that as a particularly convincing argument but must recognise it as an 'official' view.
Another reason to support a more measured approach to the easing process from here would be any central bank's desire to remain relevant. Given the RBA's expectation that the unemployment rate is likely to be deteriorating through 2009 and (probably) beyond it is preferable to have some 'ammunition' to be seen to be still addressing the challenge. Hence there is this tactical trade-off between being pre-emptive but remaining relevant.
Later in the discussion he returned to that theme. He noted that the point of going early was that the longer you wait, the more you will need to do, and the task was to try to head off the deterioration before it gained momentum.
While he did not dismiss the possibility of the rate being cut to 2 per cent, he seemed dismissive of the relevance of other central banks going to zero. He explained that such action was necessary because the monetary policy transmission mechanism was not working in those countries – mortgage and other private sector rates had not responded either because mortgage rates were typically fixed (US, Japan, Germany) or the banks were in such a parlous state that they needed to widen spreads to support profits.
There was no consideration of the theory that while below 2 per cent it might be difficult in Australia to get any traction to private rates, the currency would take over as the appropriate mechanism. Hence we certainly would not lower our forecast low for the cash rate on the basis of today's speech.
Decisions on the frequency of moves from here (the size of which will be 25-50 basis points) will depend on developments in the global economy. The Governor indicated that the responses in the domestic economy were only just beginning and he appropriately pointed out the recent strong increases in housing finance data. In turn he expected that the lower rates would stimulate residential construction in recognition of the record shortages of housing.
There was also some evidence of a more positive approach to the global outlook – pointing to a sharp fall in the overhang of unsold houses in the US; "some tentative indications of a turn for the better in China"; and not being prepared to accept that the sharp contraction in production and trade in the other Asian economies was the beginning of a new precipitous downtrend. (He did however point out that Japan had just registered a stunning 3 per cent contraction in GDP in the fourth quarter).
We are less optimistic about events in US, Europe, and China and expect that the solutions that the Asian economies will have to embrace – sharp fiscal stimulus to rebalance growth away from exports towards domestic demand – will initially be spurned in favour of the old solutions. That will see the deterioration in our major trading partners continue through 2009.
Whether the RBA decides to cut by 25 or 50 basis points in March will probably be dependent on economic developments over the next week, but we would be very surprised if the decision was made to defer any action at all, particularly given the spectacular unravelling of the economies of our nearby trading partners. At this stage our important forecast is our choice of the final target low point, which is now not likely to be reached until the second half of 2009 instead of our previous view for the June quarter.
Bill Evans is Westpac's global head of economics.