On November 4 the Reserve Bank of Australia decided to reduce the cash rate by a further 75 basis points to 5.25 per cent. This was a surprise: particularly when seen in the context of recent statements by both the Governor and Deputy Governor (who indicated in a speech as recently as October 30 that high inflation could limit the manoeuvrability of monetary policy) and the fact that the markets seemed content to frank the almost unanimous views of economists that the move would be 50 basis points.
The dominant explanation for the previous surprise 100 basis point cut in October was the extreme dislocation of global financial markets. Since then, LIBOR has fallen from 4.5 per cent to 2.85 per cent signalling considerably greater stability in global markets. Banks have also been given government guarantees to support bond issues in the global term markets and there is early evidence that these issues are being adequately received. Our conclusion is that we have passed the worst of the credit crisis.
However the Reserve Bank may be less convinced. Significantly, the Governor made no mention of this improved stability on November 4, preferring to highlight the downside risks to the economy. There was a clear intention to make a strong case to justify the surprisingly large move.
Undoubtedly, the key drivers of this decision were the deteriorating outlook for global growth and the substantial falls in commodity prices over the last month in particular. For example, Westpac has lowered its forecast for global growth in 2009 from 3.0 per cent (also IMF forecast) to 2.25 per cent. Westpac’s commodity price index has fallen by 18 per cent in US dollars terms since the last Board meeting, while the share price index has fallen by 5.7 per cent.
The Bank acknowledged the likely stimulus from the fiscal package, the previous rate cuts and the depreciation of the Australian dollar, but came down on balance in favour of a lower growth profile for spending and activity than had been expected at the time of the last Board meeting. Given this impressive array of stimuli this is a significant indication as to how concerned the authorities are about the likely damage to the economy from the global crisis.
There is also increased confidence in the outlook for inflation. At the last Board meeting, the view was that inflation would begin to fall in 2009 – this week's Statement refers to "will soon start to fall”. The December quarter inflation read is due on January 21 next year.
Westpac has lowered its forecast for the low point in this interest rate cycle from 4.50 per cent to 4.00 per cent. We believe that will be around 80 basis points below ‘neutral’ and compares with the low point in the previous cycle of 4.25 per cent. In that cycle, housing credit was growing by 15 per cent when the RBA stopped cutting rates, whereas in this cycle, housing credit growth has slowed to 7.2 per cent (six month annualised). The big difference between that cycle and the current one is inflation. In 2001 underlying inflation peaked at 3 per cent whereas it currently stands at 4.8 per cent. But the message is abundantly clear that inflation is a challenge for another day. The immediate task is to bring interest rates firmly into the expansionary zone.
We expect that the next move will be a 50 basis point cut on December 2, laying the foundation for a low point of 4.00 per cent by March next year. The smaller anticipated move is consistent with rates moving below neutral. As rates move below neutral, so the risk of over stimulating increase, and the normal conservatism of central bankers takes hold.
However, we must note that whereas following the 100 basis point move in October, the Statement advised that "The Board does not ... regard that movement as establishing a pattern for future decisions”, the latest move did not attract a similar qualification. Recalling that the Board does not meet in January, the probability of a move larger than 50 basis points in December is clearly not zero. Equally, the risks are clearly to the downside of a 4.00 per cent bottom for the cash rate.
A low point of 4.00 per cent is not aggressive in the current circumstances. We expect US Federal Reserve to cut to 0.50 per cent; European Central Bank to go to 2.00 per cent and Bank of Japan has already gone to 0.30 per cent. Further, we stick with our view that rates will be rising in the second half of 2010. The excess liquidity which central banks are manufacturing to deal with the current crisis is likely to eventually stoke inflation and yield curves are likely to steepen further in recognition of that outcome.
After the world runs out of asset bubbles (equities; housing; commercial property; credit; and commodities) it may be time for the "cure” to the damage from these bursting bubbles: generating a bout of old fashioned goods and services inflation.
Bill Evans is chief economist at Westpac.
