WEEKEND ECONOMIST: Rate expectations

The Reserve Bank Board meets on November 6 next week. We expect the board will decide to reduce the cash rate by a further 25bps from 3.25 per cent to 3.0 per cent.

Markets are currently quite uncertain about this outcome with current pricing indicating a 55 to 60 per cent probability of a cut.

Last week we provided a detailed analysis as to why we did not believe that the September quarter inflation report would cause the board to delay its decision to cut rates next week.

However, if there is no move next week and there is no indication in the statement to the contrary, then we can only conclude that the inflation report has (in our view unjustifiably) prompted the Bank to delay any easing decision until there is more information available including the inflation profile. That would tend to indicate that the next cut could not be expected before February 2013 when the December inflation report will be available.

We think that cutting next week will be good policy. Whenever there is genuine doubt around a policy outlook it is prudent to forecast good policy.

We think that the overriding issue is that the bank has a plan. That is best explained by the governor's statement following the October board meeting.

"Looking ahead, the peak in resources investment is likely to occur next year and may be at a lower level than earlier expected. As this peak approaches it will be important that the forecast strengthening in some other components of demand starts to occur".

Of course these "other components" are exchange rate and interest rate sensitive parts of the economy. While the exchange rate is generally outside the direct control of the authorities interest rates are their prime policy weapon. Furthermore, interest rates are not particularly low yet.

The 'neutral' cash rate is estimated to be around 3.9 per cent – that compares to 5.5 per cent at the beginning of the global financial crisis. In the previous two easing cycles, rates bottomed out at 150 bps in 2009 and 125 bps in 2001 below the neutral rate. A cut to 3 per cent would still only see the cash rate around 90 bps below neutral. Given the current contractionary stance of fiscal policy, and rigidities in the Australian dollar in the face of falls in the terms of trade (we estimate 10 per cent in the six months to end December), financial conditions are actually considerably tighter than the last time rates were 90 bps below neutral.

The most significant development through the week was an important speech from RBA deputy governor, Philip Lowe. As part of the speech he "updated" the Bank's view on China. In September governor Stevens noted that, "some recent indicators have been weaker which has added to uncertainty about near term growth". Dr Lowe's comment this week was less concerning, "earlier in the year, growth in China was slowing, but the recent data have had a more positive tone and suggest that growth in China has stabilised, albeit at a lower rate than over the past decade".

If the rationale behind the rate cut in October was purely uncertainty around China then Dr Lowe's comment would almost be a "game changer". However we expect that other factors are also at play.

For example, views around other major global uncertainties have not changed. Dr Lowe attributes The US "fiscal cliff" and Europe's fiscal and banking problems to increasing uncertainty in Australia which "leads to decisions being delayed". There is no hope offered that this impact on the Australian economy has, or is likely, to ease to any marked extent. Our assessment is that the bank's thinking on Europe is much more sceptical than the markets' and much more in line with our own views – there appears to be little change in this regard in Dr Lowe's remarks.

However Dr Lowe's key theme is that quantitative easing by the central banks in the major developed economies leads to institutions looking for alternative investments apart from large deposits earning near zero at the central bank. This search is not restricted to domestic assets but also includes foreign assets. Increased demand for foreign assets raises the exchange rates in those countries, "the contractionary effects of an appreciation can be countered with more stimulatory domestic policy setting – including through lower interest rates".

Countries which are listed as having low nominal interest rates and a relatively high exchange rate are Canada; South Korea; Switzerland; New Zealand and some Nordic countries. He does not include Australia specifically in this list but does describe interest rates as "relatively low compared with historical averages".

We are not denying that Australia's rates are lower than average but do note that compared to other easing cycles rates have the scope to fall considerably further.

He also seems somewhat reserved on whether current settings are having any success in achieving the Governor's objective of, "strengthening in some other components of demand".

He refers to "slight improvement in the property market". That may have been based on information to date that in the three months to September house prices have increased by 2 per cent, nationally, following a fall of 1.3 per cent over the previous six months. Prices were reported on November 1, two days after the speech, to have fallen back by 1 per cent in October.

He also noted that lower rates were not encouraging household borrowing rather households were opting to repay loans more quickly. Since the speech we received further confirmation of that process with housing credit growing by only 0.37 per cent in September with the annual growth rate falling from 4.8 per cent to 4.7 per cent.

However, markets and some journalists seized on the sentence, "The very low interest rates in many other economies should not be seen as a good thing or something to aspire to" – these rates reflect a country's "difficult economic circumstances and low risk adjusted returns available on new investment".

My take on that comment is that it is referring to the developed countries with effectively zero interest rates that are now resorting to quantitative easing due to moribund economic prospects. It is not referring to the other group of countries which have been affected by the currency impact of QE in the developed world and have responded with lower rates. My read on the speech is that such a response is almost an inevitable reaction to the QE in the developed world – it is not some overreaction by these central banks.

In short, this important speech should, from my perspective, not be interpreted as some signal that the bank has decided that rates cannot be pushed any lower.

Bill Evans is chief economist at Westpac