Following the 50 basis point cut in the official cash rate by the Reserve Bank of Australia in May we revised our cash rate forecast to include two more cuts in the June-August period of 25bps each.
At the time that move was a little bolder than consensus, but positively timid compared to market pricing which had raced to a forecast of total cuts of around 100bps.
Since then, as the news from Europe has deteriorated further the market has now moved to expecting cuts totalling around 140bps by year's end with 100bps in that June to August 'window'. That pricing broadly incorporates a 50 per cent probability of a 50bp cut in June; around 100 per cent probability of a total of 75bps by July and 100 per cent probability of 100bps by August.
In other words the market is pricing a certain combination of one 50 and one 25 in June-July and a certain follow up 25bps in August. The final '40' is distributed as a 'certain' 25 in the September/ October 'window' with around a 50 per cent probability of a further 25bps by year's end. That would see the official cash rate between 2.25 per cent and 2.5 per cent by year's end.
While we expect that this total easing of 140bps which the market has embraced is 'just a number' largely being driven by offshore speculators who see Australian rates as particularly vulnerable to a European melt down, there is some rationale to the pricing.
Recall that the Reserve Bank describes the current policy setting as 'mildly stimulatory'. That is because its measure of 'neutral' has been reduced from 5.5 per cent prior to the Global Financial Crisis to 4.1 per cent today as the spread between the official cash rate and private sector rates (best summarised by the standard variable mortgage rate, SVMR) has widened by 140bps. With the official cash rate only 45bps below neutral, policy should be appropriately labelled as only mildly stimulatory.
In the two previous easing cycles in 2008-09 and 2001 the official cash rate bottomed out at 150bps and 125bps respectively below neutral. The calculation as to what margin below neutral current market pricing is expecting depends on an assessment as to the impact of the 140bps of official rate cuts on neutral.
For instance, if the 140bps of cuts translated into 140bps of reductions in the SVMR then neutral would be unchanged at 4.1 per cent and the official rate would bottom out around 175bps below neutral – a much more stimulatory setting than in any previous easing cycles since the 1989-91 recession.
On the other hand, if the response from the commercial banks to the 140bps of rate cuts was exactly equivalent to the response we observed in May (average reduction in the SVMR of 36bps following a 50bp cut in the official cash rate) then neutral would fall to 3.6 per cent and with the official cash rate at 2.35 per cent the 'margin' at 125bps would be comparable with 2001 and less stimulatory than 2009.
On the assumption that the 140bp cut would mean a margin below neutral of between 125bps and 175bps, the assumed policy stance of market pricing is comparable with 2001 and 2009.
However, there is one inconvenient complication. By the time the extremely stimulatory policy stance had been reached in 2001 and 2009, the unemployment rate had risen from the low point, which in each case was around a year prior, from six per cent to 7.1 per cent and four per cent to 5.9 per cent respectively.
Now there are complications with the current print on the unemployment rate of 4.9 per cent. The rate has not increased at all from a year ago. That has been largely due to the reduction in the participation rate, which has reflected the significant structural change affecting the Australian economy.
In the budget papers, the government forecast the unemployment rate to increase to 5.5 per cent by mid-2013 with the peak probably sometime earlier. That profile, which broadly concurs with our views, is not comparable with the rapid labour market deteriorations in 2001 or 2009. On that basis it is hard to argue that the bank would see the need to push policy to the stimulatory stance currently envisaged by market pricing.
Our current outlook for the global economy (incorporating stimulus packages likely in Europe, China and the US) points to a labour market cycle more comparable with the easing cycle of 1996/97. On that occasion the increase in the unemployment rate was 'only' around 0.5 per cent from 8.3 per cent to 8.7%. The official cash rate bottomed out at 50bps below neutral, an appropriately less stimulatory stance than in 2001 and 2009.
The question is whether the sharp move in market rates should prompt us to adjust our current call for a further cut in the official cash rate of 50bps over the June/August period.
Based on the May experience, another 50bps in cuts to the official cash rate would reduce neutral to 3.95 per cent and the official cash rate would be 70bps below neutral.
That looks to be comparable with the 1996-97 episode although the big difference is that like 2001 and 2009 and unlike1997 (when movements occurred before the Asian Crisis) markets are being driven by global risks. We expect that the RBA would see the current threats in Europe as potentially more dire than December last year when liquidity issues, rather than the future of the euro, dominated concerns.
We were also disappointed at the poor response of consumer sentiment in May and the continued deterioration in respondents' already weak confidence about job prospects. That prompted us to subtly moderate our view from 50bps in June-August to 'at least' 50bps. With the RBA's concerns around Europe and the assessment that policy is only mildly stimulatory, the case for an immediate rate response is respectable. In fact a case to front-load the cut to offset any further confidence damage from Europe is also respectable.
But on our figuring, the case for the extent of rate cuts currently expected by the market is dubious. These issues will be affected on a daily basis by developments in Europe. We certainly believe that it is naive in the extreme to expect that there will not be a further stimulus package in Europe to settle current fears. With all this in mind, we are reserving our right to review our forecast on the RBA's decision at its June 5 board meeting until next week when more information will be available around the global situation.
Bill Evans is Westpac’s chief economist.