WEEKEND ECONOMIST: On hold for now

The RBA is likely to leave rates on hold next week. The bank knows Australia's staggeringly strong fiscal position has deteriorated quickly and monetary policy will need do more heavy lifting later on.

The Reserve Bank Board meets on May 5 next week. We expect the Board will decide to hold rates steady at this meeting although we do not believe that the easing cycle is over. We retain our long-held view that the RBA will be cutting rates in the second half of 2009 to a low of 2 per cent, with downside risks.

The pause in May will purely be in recognition that the Bank assesses that it has limited further scope to cut, and that scope will be better used when the employment data in particular starts to deteriorate more rapidly during the second half of 2009.

RBA decisions in 2009 will be about tactics rather than pure economics. If economics alone dominated policy then we would have already seen bigger cuts than the zero (March) and 25 basis points (April). Economics would dictate that rates should be cut as far and as quickly as possible to put maximum stimulus into the economy.

That has not happened so far this year and we expect that will continue to be the preferred policy approach. Certainly there can be no argument that rates should continue to fall in Australia. Indeed the pressure on monetary policy is beginning to intensify further as the flexibility of fiscal policy is diminishing.

In our detailed Budget Preview, which we will release next week prior to the May 12 Budget, we estimate that the "starting position" of the Budget in 2009-10 will be for a deficit of around $50 billion (4.3 per cent of GDP) with a similar "staring point" for 2010-11 blowing out to $62 billion (5.1 per cent of GDP). The "starting position" is defined as the likely budget position if there are no new initiatives in the Budget or if any initiatives are funded by offsetting savings.

We expect that there will of course be a range of new initiatives covering pensioners; unemployment benefits and infrastructure. The net effect of these initiatives could be to add, say, $5 billion to the deficit each year after "savings" are achieved through some revenue measures, possibly associated with middle class welfare and business subsidies. That would see the deficit expand to 4.7 per cent of GDP in 2009-10 and 5.5 per cent of GDP in 2010-2011.

Already the fiscal stimulus in this recession is much larger than we have seen in previous recessions. In the 1983 recession the deficit peaked at 3.3 per cent of GDP in 1983-84 and in the 1991 recession the deficit peaked at 4.1 per cent of GDP. The fiscal stimulus over the 1980's recession period peaked at 3.5 per cent of GDP; 5.6 per cent of GDP in the 1990's recession and already looks like 7.2 per cent of GDP assuming "only" $5 billion of net new initiatives in 2009-10 and zero net impact of new initiatives on Budget night in May 2010. As the May 2010 budget is a potential "election budget" this assumption seems to be rather conservative.

Certainly the starting point in terms of net debt is much more favourable for the Federal authorities than in those earlier recessions. In June 2008 the federal authorities had negative net debt of $42.9 billion (–3.8 per cent of GDP) compared to net debt of 3.4 per cent per cent of GDP in June 1982 and net debt of 4.1 per cent of GDP in June 1990.

However, the situation for the federal authorities has become more complicated due to the global financial crisis. The Commonwealth government has acquired a range of contingent liabilities through its guarantees for banks' wholesale bond issues and the likely guarantees associated with the semi-government authorities. A Commonwealth guarantee is now attached to $89 billion (7.6 per cent of GDP) of bank securities with up to a further $20 billion to be issued in 2009. It is probable that the semi-government authorities will accept the Commonwealth authorities' offer of guarantees for $111 billion of outstanding securities and potentially $50 billion of new issuance over 2009-10 (another 14 per cent of GDP).

If we accumulate a further, say, $100 billion of new bank issuance in 2010 (possibly less as banks' balance sheets grow much more slowly in 2010) with the stated semi-government program and the likely combined Commonwealth deficits over 2008-9 to 2010-11 of around $160 billion (or 14 per cent of GDP) we start to see a picture where the Commonwealth liabilities and contingent liabilities grow from a net debt position of negative 3.8 per cent of GDP to 14 per cent (Commonwealth) plus 18 per cent (banks) plus 14 per cent (semis) totalling 46 per cent of GDP.

Now, this number still compares well with the 2008 starting points of the majors – Europe (42 per cent), UK (41 per cent), US (40 per cent) and Japan (87 per cent). Further these starting points have also blown out substantially as the majors deal with their own fiscal stimulus packages – IMF estimates that the budget deficits of the major economies will increase from 2 per cent of GDP in 2007 to 10.5 per cent of GDP in 2010. These countries are also providing guarantees for their banks, although Australia's banks have been relatively larger users of the guarantee facility than other countries due to the much greater reliance which Australia has put on its banking system to fund its foreign liabilities.

The purpose of this analysis is to highlight how quickly Australia's staggeringly strong Commonwealth fiscal position has deteriorated as a result of the global financial crisis. The likely result of this is that the Federal authorities will assess that they have limited flexibility to continue with aggressive discretionary fiscal stimulus particularly in such hostile global capital markets.

Less flexibility on discretionary fiscal policy highlights the need for monetary policy to do more. In fact, we emphasise that our 2 per cent target has downside risks. It is unlikely that the banks will be able to pass much on to retail borrowers (given the need to offer reasonable deposit rates to savers) if the RBA decided to push rates below 2 per cent. However, lower bill rates would certainly assist corporates and overall bank funding costs.

Bill Evans is chief economist as Westpac Banking Corporation.

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