WEEKEND ECONOMIST: How deep will the RBA cut?

Next week we will see the RBA's minutes of the August 5 board meeting and we will be looking for clues with regard to the likely result of the upcoming September 2 board meeting. Markets and most commentators are resigned to the RBA delivering a rate cut at the September meeting and we strongly concur. The two key issues now are, for the short term, whether we see a 50 basis point cut on September 2 and the overall profile of the rate cut cycle.

Last week markets assessed the probability of a 50 basis point cut at around 50 per cent. That was cut to 25 per cent mainly because the wording of the Statement on Monetary Policy (SoMP) did not indicate any real 'urgency'. But now that has moved back out to 50 per cent.

As with the Statement by the RBA governor Glenn Stevens following the board meeting in August, the language in the body of the report was reasonably mild. Indeed, the section on forecasts talked of a modest reduction in growth forecasts from the May SoMP. Recall, however, that the RBA's growth forecast in May was substantially lower than market expectations, so to further lower forecasts represents a considerable reduction in growth outlook from the consensus forecasts in May.

We were also surprised to see the RBA's employment growth forecast of only 0.75 per cent, implying a full 1 per cent rise in the unemployment rate over the next year. That is a dramatic slowdown in growth from 2.5 per cent over the last year. It implies a 1 per cent rise in the unemployment rate over the next year. Note that in the last two slowdowns – with which a full 2 per cent rate cut cycle was associated – the unemployment rate rose by 0.6 per cent (1995-97) and 1.1 per cent (2000-01). The 1 per cent rise that is currently forecast will be right at the Bank's threshold limit and represents around the biggest rise in the unemployment rate since the recession, when it rose by 5.2 per cent from 5.6 per cent in December 1989 to 10.8 per cent in February 1993.

The numbers in the forecasts were considerably 'down beat', if not the language. The language in the body of the SoMP tends to reflect staff views. The language in the minutes will reflect the sentiment of the board.

We are still attracted to a first move of 0.5 per cent for a number of reasons:

– Most importantly is that the 'safest' time to cut by a larger than normal amount is at the beginning of the cutting cycle. The previous two easing cycles began with 0.5 per cent moves. Starting levels were similar to the current starting level of 7.25 per cent (7.5 per cent in 1996 and 6.25 per cent in 2001). The beginning of the cycle is the best time because that is the time when rates are the furthest away from neutral and clearly in contractionary territory. The risk of overstimulating is at its lowest when rates are furthest away from neutral. As the easing cycle progresses and rates become more stimulatory the risk of a large move overshooting becomes greater.

– The Bank has given the market ample time to prepare for this move. We will be most interested to assess from the minutes as to whether there was a view that rates could be cut in August but delayed because markets were not prepared. A 50 basis points move in September would be seen as catch up for a move that was considered appropriate in August.

– The Bank's biggest concern appears to be the sudden collapse in credit growth. We agree that the slowdown is much more of a demand event than driven by supply. Cutting rates lowers borrowing costs and stimulates the demand for credit. That has already happened in the swap and bank bill markets. We assess that swap rates have fallen by around 70 basis points since markets detected the RBA's intention to cut rates. In the last two days an RBA Assistant Governor and the Deputy Governor have both emphasised the need for RBA rate cuts to be passed on in full to variable rate mortgage borrowers. The experiences of the Bank of England, which cut rates three times by a total of 0.75 per cent only to see mortgage rates rise by 0.5 per cent, will be on the mind of the authorities.

The wording in the board minutes will be crucial in our review of the most likely size of the first cut.

However, the size of the first cut is much less important than the overall profile of the cycle. We have argued that it will be different to the last two easing cycles. These have been remarkably similar – lasting around 12 months and totalling 2-2.5 per cent in cuts. These previous easing cycles coincided with inflation either well contained or actually falling. Policy could be pushed from contractionary to stimulatory without being too concerned about overstimulating.

This time inflation will still be an issue early next year. The RBA will be aiming to restore credit growth to some more normal pace and then stop easing in the expectation that demand will still be soft; spare capacity will be emerging and inflation pressures can ease. The actual movement to neutral – 5.5 per cent and possibly beyond – will be delayed until 2010.

Markets are currently pricing cash rates to be down by around 0.75 per cent by year's end. We assess that as being about right (we expect 0.75 per cent). They are also looking at one more rate cut by March – fairly close to our own view that rates will bottom out in the first stage of the cycle at 6.25 per cent by March. They are also fairly conservative on the likely follow through on rate cuts from around March. It is certainly our view that rates will be stable for most of 2009 as the RBA resumes its inflation fighting rhetoric.

For now, markets are pricing a rate profile close to our view with the exception of the size of the first move.

Bill Evans is chief economist at Westpac Banking Corporation.