WEEKEND ECONOMIST: A week of trauma

While we expect the RBA to cut rates by 0.25 per cent on October 7 we have been very surprised by the level of confidence exhibited by market pricing. Following the market trauma on Thursday, the market had a 100 per cent probability of a 50 basis point rate cut on October 7. We would find it very difficult to envisage a realistic scenario that would see the RBA cutting by 50 basis points in October. With more calm in the market on Friday, market pricing has fallen back to 140 per cent, still giving a near 50 per cent probability to a 50 basis point cut and a "certainty" to a 25 basis point cut.

Furthermore, market pricing appears to be anticipating that the cash rate will be between 5.75 per cent and 6 per cent by the second quarter next year. We don't believe that the market can be seriously expecting that the bank variable mortgage rates will be lowered by a further 100-125 basis points over the next six months. The market must be expecting considerable "slippage" in the transmission of monetary policy.

The Reserve Bank has made it clear in its forecasts in the Statement on Monetary Policy that growth in non-farm GDP needs to slow to around 1.5 per cent through the year to the first half of 2009. (Forecast revised to this scenario during the Governor's appearance before the Parliamentary Committee.) Given that the first quarter registered 0.5 per cent growth the next three quarters need to average around 0.35 per cent to achieve that target.

There are decent reasons to believe that the RBA has recently become more positive about the growth outlook. The slowdown in non-farm GDP growth in the first half of 2008 from 4.2 per cent in 2007 to 2.5 per cent annualised was all contributed by the consumer. Consumer spending grew at a 1 per cent annualised pace in the first half of 2008 compared to 4.5 per cent in 2007. Business investment growth held around that 12 per cent pace which it registered in 2007 in the first half of 2008. Housing investment actually picked up marginally to around 2 per cent from "flat" in 2007.

But since those RBA forecasts were set we have seen evidence of the consumer "stirring". Following the 8 per cent fall in the petrol price and the September rate cut the Westpac–MI Consumer Sentiment Index has recovered by 17 per cent. While the new limited sample for retail sales makes the traditional seasonally adjusted read unreliable, we can still assess the report for the large retailers where the respondents are the same every month. Spending with large retailers surged by 1.8 per cent in July pointing to some recovery from the dismal contraction in consumer spending which we saw in the June quarter.

For business, we have seen the Capex Survey which on face value projects a 29 per cent increase in nominal business investment in 2008-09. We have discussed that Survey at length in the past and the RBA has also indicated considerable scepticism, however, the flavour of the Survey indicates that business investment is unlikely to be a major drag on growth in the next year or so.

The Westpac–ACCI Survey was released on Thursday. While the Composite Index for the Survey fell from 53.9 to 50.8, it still indicates expansion and is still above the low points in 2001 (39.7) and 1995 (38.2).The most important aspect of the Survey is a sharp 10 point fall in the Labour Market Composite indicating a slowdown in annual employment growth from the current 2.3 per cent to 1 per cent by the first half of 2009.

The clear message from the RBA statements is that policy easing will be gradual and data dependent. We believe that the "gradualism” will start after the October move with a maximum of two more cuts over the following 6 months.

One has to say that the data has not been consistent with the Bank's current forecast of an average non-farm GDP growth pace of only
0.35 per cent for the next three quarters. The reason why we support a 0.25 per cent cut in October is because we expect that the Bank remains disturbed by the sudden fall in credit growth and the sharp increase in funding costs for the banks.

Australian banks fund themselves broadly 50 per cent with retail deposits and 50 per cent wholesale. Because the banks are required to "front" much of Australia's foreign debt, around 60 per cent of wholesale deposits are sourced offshore. Around 30 per cent of wholesale deposits are term deposits with maturities longer than one year.

The credit crisis has pressured all aspects of funding costs. Spreads for "typical" term funds of around three years may have recently increased from 100 over swap (out from 10 over swap prior to the crisis) to 120-150 over swap. As the "cheap" pre-crisis term funding shortens it must be replaced by new expensive term funding. Liquidity pressures have recently seen the cost of short term wholesale funding rise relative to the risk free rate. Even retail deposits have become more expensive for banks as regional banks with no access to global capital markets pressure that source of funds.

On the face of it these pressures will increase the prospects of a diluted impact of monetary policy but huge uncertainties remain. Market pricing seems to be adopting the most extreme of possible outcomes.

Bill Evans is chief economist at Westpac Banking Corporation