Reserve's rethink points to an economic morass

What looked like expansionary trends emerging within the Australian economy have proven to be otherwise, forcing the Reserve Bank to administer a reluctant jolt.

The Reserve Bank’s decision to, somewhat unexpectedly, lower the cash rate again is disconcerting. In effect it signals that the bank believes the economy is weaker than it had previously believed.

Only a month ago the central bank was referring to indications that the "substantial" easing of monetary policy since November 2011, when this cycle of rate-cutting which has lopped 200 basis points off the cash rate started, was having an "expansionary" effect on the economy.

Now it says the effects of those rate cuts, which had pushed borrowing rates close to previous lows, are continuing to emerge. Those effects have largely been to push savers into high-risk and higher-yielding investments, pushing share prices up.

Demand for credit, however, remains "subdued". It is quite obvious from the very low levels of credit growth that households and businesses have battened down the hatches, too nervous to take risk. Whether its retailers or the building and construction sector there is a sense of increasing pressure which is just starting to show up in a slight rise in the unemployment rate.

While the Reserve Bank, understandably, made no reference to the poisonous politics of this election year, or the rapidly disintegrating fiscal policies of the Gillard government, that would have to be a factor in the increasingly defensive postures adopted by households and businesses. Next week’s budget and what it reveals about the financial position of the government has the potential to increase the levels of anxiety.

The bank does refer to the "unusual" strength of the Australian dollar, which has remained at historically high levels over the past 18 months despite the heavy falls in commodity prices and which has had a punishing impact on the non-resource side of the economy in particular.

The dollar was down ahead of the rate decision, amid rumours that George Soros had taken out a short position, and fell further once the cut was confirmed, albeit to just under $US1.02, a level that still offers no relief to manufacturers and other trade-exposed industries.

With much of the rest of the world printing money furiously and setting their rates at levels that are negligible it probably shouldn’t be surprising that the dollar hasn’t been traded down and the working assumption probably needs to be that it will continue to remain at elevated levels – unless the Australian economy goes seriously off the rails.

The resources investment boom is scheduled to peak this year and there isn’t much in the pipeline behind it, even though the Reserve Bank is hopeful that there might be some increase in non-resource sector business investment over the next year.

Given the magnitude of the fiscal challenges emerging, the next government is going to face some real issues in trying to maintain some growth while also trying to get the budget back into a more sustainable position.

The Reserve Bank has had a bias towards further easing for most of this year but appeared confident that its past rate cuts would eventually flow through to a pick-up in activity and growth.

Today’s rate cut is an admission that hasn’t occurred and that the bank is concerned enough about the fragility of the economy that it decided to use up some of its dwindling firepower – the cash rate is now down to 2.75 per cent – to try to promote some growth.

That might be good news for borrowers, assuming the banks pass the 25 basis points reduction on in full (which NAB did almost before the ink had dried on Glenn Steven’s statement) but it is, perversely, also a sign of an economy weak enough (travelling "below trend" in the bank's language) to prompt the board to move again. That’s not necessarily good news for anyone else.