WEEKEND ECONOMIST: Get set for a big cut

Rates look certain to fall 0.5 per cent in September, kicking off a two-staged cutting cycle that will continue until the first half of 2010.

With the Governor’s statement following the August board meeting we now expect that the Bank will cut rates by 0.5 per cent following its September 2 board meeting. That will be the first step in a two-staged cycle which will eventually bring rates down to 5.5 per cent in the first half of 2010.

The two previous rate cut cycles have started at similar cash rate levels as we have today (7.5 per cent in July 1996; 6.25 per cent in February 2001). Both cycles began with a 0.5 per cent cut; spanned 10-12 months; and totalled 2.5 per cent and 2 per cent in cuts respectively. This cycle is likely to be longer (see below) but start with a similar move. This larger-than-expected initial move seems appropriate given the context of the Bank’s decision to cut rates.

The RBA has been disturbed by the rapidity of the economic slowdown which has been complicated by the credit crisis. That has manifested itself in the banks raising variable mortgage rates by 0.5 per cent more than the RBA tightenings; risk margins increasing for businesses; and certain quantitative lending constraints being imposed by banks, particularly foreign banks which are suffering severe capital constraints.

A decisive move to temper the pace of the current slowdown seems an attractive option for the RBA. In May, the RBA effectively set out its plan to slow domestic spending growth in the economy from 6 per cent in 2007 to 2.5 per cent in 2008 and 2 per cent in 2009. An extended period of consistent below-trend growth was considered necessary to bring inflation down from 4.4 per cent to 2.75 per cent by the end of 2010. Recent data reads on business and consumer confidence; business and housing credit growth; new lending; and consumer spending (retail sales) point to growth slowing even more precipitously than originally expected in the "plan”.

As a result the Governor issued a statement following the August 5 board meeting indicating as strongly as can be done in "RBA speak” that the Bank will cut rates in September to avert this unwelcome "overslowing”.

However, unlike the previous two easing cycles it is unlikely that the Bank would move smoothly to an expansionary policy setting which is likely to be a level of rates between 5.5 per cent and 5 per cent. The inflation task is far from completed and the objective will remain to move growth back onto a sustainable below trend path (probably around 2.5 per cent to 3 per cent) during the course of the second half of 2008 and 2009.

That probably means that this easing cycle will be two staged, with the Bank likely to pause in the cycle at around, say, 6.25 per cent sometime in the first quarter of 2009. Once the slower growth is perceived to be impacting inflation and with an associated rise of around 1 per cent in the unemployment rate, the RBA can resume cutting to eventually bring rates down to neutral (5.5 per cent) or even slightly lower by mid 2010.

Much will depend on the impact of the credit crisis and the resulting smoothness of the transmission of rate cuts to households and business. Any disruption of that process will mean even lower RBA rates will be needed to stabilise growth.

These risks are spectacularly exemplified in the US where mortgage rates are higher now than prior to the Fed cutting from 5.25 per cent to 2 per cent due to the lenders’ higher funding costs; the perceived credit risk of the borrower; and capital constraints of the lending institutions.

We agree with the RBA that the economy has slowed faster than the 2 per cent to 2.5 per cent "target”. This is evident from retail sales, which contracted over the first half of the year (in real terms) and from the subdued credit numbers. We estimate that domestic demand slowed to an annualised pace of 1.6 per cent in the June quarter, down from 3.6 per cent in the March quarter and almost 6 per cent in the December quarter. Australia’s terms of trade boost will jump by 15 per cent this year – thereby adding 3 per cent to national income and thus providing support to economic activity and to the labour market over the year ahead.

Associated with the commodity boom and the resulting surge in resource investment, exports have strengthened in the June quarter and net exports have added 0.3 per cent to quarterly GDP growth – on our estimates. That stimulus will also assist the RBA in averting a much sharper slowdown in 2008 and 2009.

Of course we will be scrutinising the Statement on Monetary Policy that will be released by the RBA on August 11 next week. We do not expect to find any "surprises" such as significant qualification of the Governor's fairly explicit remark in his statement on August 5.

We will be very interested in the forecast tables. Note that these forecasts are made on a no policy change basis. So we will get a sense from these forecasts of how much the economy is perceived to have slowed by relative to the May forecasts. That will be a useful way of assessing the Bank's "pain threshold" since we expect there will be a significant downward revision of growth that was being determined by the Bank as being unacceptable and therefore requiring the early beginning of the rate cut cycle. We will then be watching the February SOMP to assess whether growth forecasts have been revised up sufficiently (on a no policy change basis) to signal a temporary end to the cutting cycle.

The inflation forecasts will be less interesting. With slower growth the forecast slowdown in annual inflation (say in 2009 and second half of 2008) will be faster but because of the higher "starting point" (4.4 per cent instead of 4 per cent as we saw in May) the end point will probably remain at end of 2010.

However, the forecast will need to provide sufficient "room" to allow the target of bringing inflation back to target level by end 2010 even with faster growth as the economy responds to lower rates.

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