The RBA should have held fire

The central bank's decision to cut rates today shows how worried it is, but it was premature because it's too soon to measure the impact of the last rate cut and the Greek elections could be another eurozone flashpoint.

The Reserve Bank could easily have sat on its hands for a while longer and waited to see how the crisis within the eurozone and the slowing of China’s economy plays out before following up last month’s 50 basis point cut to the cash rate. The fact that it didn’t signals its concern about the conditions both offshore and within the domestic economy.

The 25 basis point cut announced today takes the cash rate back to where it was in November 2009, when the world was emerging from the nadir of the original financial crisis and within a single 25 basis point move of the low point of that cycle in official rates. That provides a useful barometer of the current economic and financial climate.

There were a number of reasons why the RBA shouldn’t have cut today.

The new Greek elections on 17 June are likely to be another flashpoint in the eurozone crisis. European leaders are trying desperately to put together a new (some cynics might say ‘first’) ‘’masterplan’’ to escape a eurozone implosion. China is trying to rekindle growth.

Within the Australian economy we’ve yet to see the full impact of last month’s 50 basis point reduction in official rates (less what the banks retained), or the impact of the Gillard Government’s latest $2.5 billion cash splash or the recent significant decline in the value of the Australian dollar.

There was also, as discussed previously (A question of RBA firepower, 4 June) the issue of preserving as much of the RBA’s diminished capacity to stimulate as it could in case the eurozone does blow up.

There were, therefore, reasons why deferring a move until both the global and local circumstances became a bit clearer might have been a rational decision.

Yet the RBA decided to move, albeit by a modest 25 basis points, which will probably end up being slightly less than that after the banks have trimmed it to offset their increased funding costs. By itself, 25 basis points, or whatever ultimately flows through to households, isn’t going to turnaround the increasingly defensive sentiment of consumers.

That says that the RBA is concerned. It is worried about Europe. It is worried about China. It is worried about the domestic economy. As it should be.

Europe is a basket case and has, as the RBA noted, the potential to generate shocks that would be transmitted through the global financial system and economy. Issues of fiscal sustainability (the eurozone’s fiscal settings can’t be sustained) and its under-capitalised banking system represents a severe threat to global economic and financial stability.

The US is experiencing anaemic growth and faces a shock of its own next January, when the withdrawal of the Bush administration’s tax cuts and mandatory cuts to government spending will yank about $US7 trillion out of its economy, probably forcing it back into recession.

China’s attempt to stamp out a property-centric bubble has been successful, perhaps too successful and it is now, in a year when its leadership will change, trying to rekindle its growth rate.

Its slowdown, and the reality that Europe and the US – approaching half the world’s GDP and China’s two biggest markets – are under continuing pressure has impacted commodity prices, and the Australian dollar and placed a question mark over the uncommitted slabs of what had been a $500 million-plus pipeline of resource project investments in this economy. It hasn’t helped, of course, that the costs of developing those mining projects have been blowing out at a greater rate than almost anywhere else in the world.

The RBA noted significant variations between sectors of the Australian economy, while saying there had been modest growth in the first part of 2012. It also referred to ‘’job shedding’’ in some industries (which appears to be accelerating in the non-resource segments of the economy) and the ‘’precautionary’’ behaviour of households and businesses. (The imminent carbon tax got only a passing reference in relation to its technical impact on inflation rather than its psychological, and real, impact on households and businesses).

After last month’s rate cuts the actual lending rates for borrowers were slightly below their long-term averages but demand for credit remains low as households and businesses continue to deleverage. Despite the cut, house prices – which had been stabilising – have resumed their decline.

The litany of woe and worry and the likelihood that the banks will hang onto at least a sliver of the 25 basis points was, if anything, an argument for a 50 basis point cut.

The 25 basis points could suggest a bet each way – preserving firepower, keeping the stimulatory impact (once the banks have taken their share of the reduction) modest, seeing whether the weakening of the dollar alleviates some of the pressures on the industrial economy and awaiting anxiously the denouement of the eurozone crisis that the Greek election and Spanish banking crisis might provide.

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