Market pricing would indicate that this easing cycle will be 200 basis points. Back in July last year when we first forecast that the next cycle in rates would be down we were mindful that previous easing cycles had gone further: 2008-09, 425bps; 2001, 200bps; 1996-97, 250bps. However we figured that the starting point for rates in this cycle was 4.75 per cent compared to much higher levels in the past – 7.25 per cent (2008), 6.25 per cent (2001) and 7.5 per cent (1996).
The factor that we did not take into account when assessing the likely extent of the prospective cycle of 2011-12 was the level of the "neutral" rate. At the completion of the rate cut cycle in 1997 and 2001 we assess "neutral" as 5.5 per cent. At the completion of the 2009 cycle we assess "neutral" at 4.6 per cent. We define "neutral" as the level of the cash rate where policy is neither stimulatory nor contractionary and note that "neutral" changes when the spread between the cash rate and private sector rates change.
The Reserve Bank, correctly, views the level of private sector rates as the key for assessing the stance of monetary policy. Since 2007, when the global financial crisis started stressing banks' wholesale funding costs, the margin between the official cash rate and the standard variable mortgage rate has widened by around 140bps.
That effectively lowers "neutral" from 5.5 per cent to 4.1 per cent.
If we consider the low point of previous easing cycles, we note that in 1997 rates bottomed out at 50bps below neutral whereas in 2001 the margin was 125bps and in 2009 it was 160bps.
The necessary degree of policy stimulus will vary with each cycle. The time at which further stimulus is no longer deemed to be required will depend on the response of the economy to the stimulus including any changes in inflation prospects. Prospects for further shocks, in particular offshore, will also be important factors. The need to push policy to such a stimulatory stance in 2001 and 2009 was driven largely by offshore concerns. In 2001 there were reasonable fears around a global recession in the wake of the bursting of the dot com bubble and the events of 9/11. In 2009, of course, the aggressive policy stance stemmed from the global recession resulting from the Global Financial Crisis.
At present the official cash rate, at 3.75 per cent, is around 35bps below "neutral". That policy stance would be described by the Reserve Bank as mildly stimulatory.
We have no particular insight into what impact future cash rate movements will have on the neutral rate. Based solely on recent history it is not unreasonable to assume that if our current forecast for the official cash rate, which is for a fall of a further 50bps, comes to pass then the spread between the official rate and neutral might widen to around 70–80bps. (When, in July last year, we forecast a 100bp rate cut neutral was around 4.35 per cent and our 100bp forecast cut would have seen the official cash rate settle around 60bps below that rate.)
The cash rate moving to be 70-80bps below neutral would be a wider margin than in 1997 but considerably narrower than 2001 and 2009. A 125–150bp margin below neutral might require a cash rate cut of 100–150bps.
That action might make even the current market expectations of a 100bp cut seem conservative.
Of course the final margin below neutral which signals that the cycle is at an end depends on the response of the economy to the easing policy. If the economy responds to the current policy stance which is only "mildly stimulatory" then no further cuts would be required from this point. (Since that policy stance has now been reached).
That prospect seems remote given the flat response of consumer sentiment to the recent cuts; the rise in unemployment expectations (from our recent survey); the confident forecast in the Reserve Bank board minutes that inflation will remain at the bottom of the target range for the next year or so; evidence from those minutes that the bank is now recognising the chronic weakness in many sectors rather than referring to "average" conditions; and, most important of all, the ongoing jolt to confidence which would stem from the crisis unfolding in Europe.
Our cash rate forecast of cuts in July and September will be constantly reviewed particularly in light of overseas developments and the response of the interest rate sensitive sectors to this "mildly stimulatory" policy. We are currently expecting rates to bottom out more in line with the precedent we saw in 1997 rather than 2001 and 2009. In those years the policy response was dominated by overseas concerns.
As the events in Europe unfold over coming days and weeks we will be constantly testing whether these global events warrant the more expansionary policy stance envisaged by market pricing and the precedents of earlier easing cycles which coincided with extreme overseas stress.
Bill Evans is Westpac’s chief economist.