Reasoning through a rate cut

The RBA's rate cut gives needed respite to Australia's retail sector and while the bank may have pulled the trigger a little early, its board was clearly most concerned about developments in Europe.

Retailers have got what they wanted, and indeed needed, with successive cuts to official interest rates. The Reserve Bank, however, appears to have been more concerned about what’s happening offshore than onshore.

With inflation receding, there’s little doubt that the RBA had the capacity to make successive 25 basis point cuts to the official rate without any significant fear of the consequences and there is also a general recognition that the non-resource side of the economy is struggling as households and businesses have shifted to ultra-defensive postures.

The mild surprise is that, if the RBA board were concerned about developments in the Eurozone and their implications for the global economy and financial system, they didn’t preserve their firepower.

Friday’s European Union summit is shaping as the decisive moment in what has gradually developed into a full-blown crisis, with major implications for the global economy, over the course of this year. With Germany and France agreeing a long-range plan for more central Eurozone fiscal policies, the summit could produce a response to the more immediate threats to European stability.

If it doesn’t, and the Eurozone continues to implode, the RBA – and the Gillard Government – are going to need to inject a lot of stimulus and liquidity into the economy and domestic financial system, which is why there was a school of thought before today that the RBA would keep the extra 25 basis points up its sleeve in case it had to embark on a series of 50 basis point reductions.

Mind you, with the cash rate now at 4.25 per cent, it still has more potential rate reductions in reserve than just about any other central bank in the developed world.

Glenn Stevens, in the statement that announced the rate cut, spelt out the linkages between what is happening in Europe and domestic circumstances.

Financial markets are volatile and financing conditions difficult, particularly in Europe (although the bank also referred to the difficult term funding conditions for domestic institutions).

"Precautionary’’ behaviour by firms and households meant the likelihood of a ‘’further material slowing’’ in global growth had increased. Commodity prices were reflecting this and taking pressure off inflation rates.

With China already slowing, in response to deliberate policy, and trade in Asia seeing some effects from the significant slowdown in Europe, the at-best modest outlook for global growth and a softening in the outlook for the domestic labour markets means that the risk of inflation has also subsided, providing the RBA with the scope to trim the cash rate again.

The big question for the RBA, the government and the retailers is whether all the banks do as they did last month (with one marginal exception) and immediately pass the cut on.

Last month National Australia Bank held onto 5 basis points, although it still has the lowest headline mortgage rate. That has been interpreted as a sign of funding pressures after NAB grew its loan book at a faster rate than the rest of the system.

All the banks, however, are having difficulty accessing wholesale funding markets and the cost of the available funds has increased significantly. Commonwealth Bank recently pulled its first issue of covered bonds because of the pricing. There would be a temptation to hold onto some of the reduction, tempered by the bashing the banks would get from Wayne Swan and their customers.

There would also presumably be a recognition that consumer-facing businesses, particularly retailers and particularly department store operators, are doing it really tough, with declines in sales approaching (and in some cases exceeding) double-digit percentages. It’s in the banks’ own interests to try to help lessen the pressures on their more vulnerable business customers and try to stimulate some confidence among consumers.

The RBA may have been mindful that its next scheduled board meeting isn’t until February, which is an eternity away given the volatile and destructive nature of what is unfolding in the Eurozone.

One suspects, however, that the board members’ Christmas holidays are likely to be interrupted by events in Europe anyway, given that the European authorities don’t appear to have the capacity to develop, agree on and implement any comprehensive response to the crisis threatening to overwhelm the region.

We’ll have a better understanding of the state of Europe, and whether the board members may have to call an ad hoc meeting, after the weekend.

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