Size all that matters now for RBA

Yesterday's inflation figures have made an interest rate cut inevitable. Now the RBA must weigh bank margins, the federal budget, China and Europe in deciding how much to lop off next month.

After last month’s Reserve Bank board meeting governor Glenn Stevens made it fairly clear that if the March quarter inflation numbers were benign the bank would be inclined to cut official interest rates. Well, the numbers are in, inflation is even weaker than was anticipated and the debate has shifted from whether the RBA will cut to how much it will cut.

With headline inflation of 1.6 per cent and underlying inflation of 2.2 per cent there was nothing in the latest numbers to suggest anything other than that the economy is continuing to weaken.

Consumer spending is at recessionary levels, the housing market is in a similar state, job losses in the manufacturing sector are mounting, the impact of the continuing (albeit tapering) boom in the resources sector isn’t flowing through to the rest of the economy and Wayne Swan is about to attempt to pull about $40 billion out of the economy, or 2.5 per cent of GDP, if not more.

Some of that may be done with "smoke and mirrors" but it isn’t going to be possible to achieve those sorts of numbers without real and very substantial cuts in expenditures and increases in government revenues. In the circumstances, the horror budget that is looming can’t be considered as anything other than a major depressant on an already weakening economy.

In that context, a reduction in official interest rates next Tuesday appears inevitable. The larger question, however, is whether that would be sufficient to blunt the negative influences now pervading the economy.

It is a question complicated by the RBA’s need to second-guess the responses of the major banks to a rate cut, given that there is a probability that they will retain at least some proportion – perhaps 10 to 15 basis points – of any reduction.

Led by ANZ, the banks have to a degree de-linked their mortgage and deposit rate movements from the RBA’s decisions and they have been making it plain that they are continuing to experience the funding pressures that have caused them to pass through rate cuts lower than the movements in official rates since the onset of the financial crisis.

If the RBA cuts the cash rate by 25 basis points next week and the banks pass on only 10 to 15 basis points of it, would the decision have any meaningful impact on the economy and the psychology of consumers and businesses? One doubts it.

That’s why there are plenty of people now focusing on the prospect of a 50 basis point reduction in the cash rate, which would allow the banks to retain their 10 or 15 basis points while still enabling a meaningful reduction to flow through to borrowers.

No doubt the RBA staff has been in close contact with the major banks to make sure they understand their likely responses to a cut. The RBA has made it clear that it does take the anticipated reaction of the major banks to rate movements into account when deciding whether to move the cash rate and the size of the movements. It is concerned not about the level of the cash rate per se, but the influence it has on the actual rates being charged borrowers.

The one issue that might make the RBA cautious about the size of any reduction would be the looming federal budget. It might want to see the nature and quality of Swan’s budget measures – how "real" they are – before moving more than the usual 25 basis points.

However, with commodity prices and the terms of trade now off their peak, China slowing, Europe still wobbling, swelling question marks over some of the biggest of the new resource projects in the pipeline, the non-resource economy slowing discernibly from already weak levels, households confronted with rising utility costs and the carbon tax imminent, if the RBA doesn’t lop 50 basis points off the cash rate next week the probability is that there will be a succession of rate cuts between now and the end of the year.

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