WEEKEND ECONOMIST: RBA ready to fight recession

With the Australian economy in recession, the RBA's decision to leave rate on hold should be seen as a tactical move. The Bank wants to be seen to be continuing to cut rates as the Australian economy contracts through 2009.

The Australian economy contracted by 0.5 per cent in fourth quarter, slowing annual growth to 0.3 per cent. Australia is now in an official non-farm recession (97 per cent of the economy) since non-farm GDP contracted by 0.2 per cent in the September quarter and 0.8 per cent in the December quarter. We expect both non-farm and total GDP to contract in the March quarter, indicating that the Australian economy will be categorised as being in recession for the first time since 1991.

Clearly the most important aspect of this release is the evidence of the surge in saving by consumers. Despite the $8.7 billion fiscal handout in early December and the 250 basis point cut in the prime variable mortgage rate through the quarter consumer spending only rose by 0.1 per cent, well below trend and at the same pace as in the third quarter when there was no such boost to household incomes. The household savings rate rocketed to 8.5 per cent from 3.4 per cent and actual savings increased from $5.7 billion in the third quarter to $15.1 billion in the fourth quarter. The government and the Reserve Bank will be disappointed at the lack of response of households to these income boosts.

This response is consistent with Westpac's Fear Index which compares the growth rate of those components in the Westpac MI Consumer Sentiment which measures both current Economic Conditions and Expectations for the Future. The assessment of current conditions has risen quickly in response to the stimulus from fiscal policy and lower interest rates. However, consumers' assessments of the future have deteriorated despite the expansionary policy. The Fear Index has now reached a level which is by far the highest on record which stretches back to 1974 and therefore covers the last two recessions.

Despite the stimulus it was bizarre to see spending on motor vehicles; clothing; leisure; restaurants/hotels; and alcohol/cigarettes all falling in the quarter. Partly reflecting this weak consumer spending we saw a sharp fall in profits which were down 5.4 per cent following annual growth in the profits over the year to September of 20 per cent. While business investment continued to grow, the growth pace is slowing. We expect that the recognition of a weak consumer who has failed to respond to the fiscal and monetary stimulus will see business scaling back investment and employment through 2009, when both are likely to contract.

These developments will alert the fiscal and monetary authorities that more work needs to done in 2009. We anticipate a further substantial fiscal stimulus from the Budget in May and continue to expect that the RBA will cut the overnight cash rate to a low of around 2 per cent. That is despite the RBA 'pausing' in their rate cut cycle at the March Board meeting. The pause brought to an end an extremely aggressive sequence of rate cuts which totalled 375 basis points over four meetings. We assess that this is a tactical move by the Bank to ensure that it has sufficient flexibility to be seen to be continuing to cut rates as the Australian economy contracts through 2009.

Unlike the US Federal Reserve, which has embraced a wide range of alternative policy instruments given that the Federal Funds rate has fallen to zero, the RBA really only has the cash rate to use to impact upon the economy. The Fed still has the option to purchase government bonds to bring down fixed mortgage rates, and is now purchasing a wide range of 'risky' assets which have been effectively underwritten by the Treasury, and therefore, using its balance sheet to ease the impact of the sharp deleveraging on the real economy.

Neither of those policies is likely to be of any attraction to the RBA. Despite the economy being reported to have contracted in the December quarter only a day after the RBA paused we do not believe that there would have been any 'regret' that the Board did not cut the rates on the previous day. With only 125 basis points to play with the Bank will need to be careful with how that last ammunition is dispensed.

At this stage we expect that there will however be a 25-basis point cut following the next meeting on April. The importance of having some 'ammunition' is more for the Bank being seen to be relevant and potentially improving confidence that the Bank is 'on the case'.

Markets are pricing the low point in this cycle at 2.25–2.5 per cent, which is a little high from our perspective. While the RBA Governor argues that the RBA does not need to cut all the way to zero because the monetary transmission mechanism is working in Australia (unlike those countries which have reached or are in the process of reaching zero) that does not justify why further stimulus should not be used if possible. We would put the reason more in terms of the effectiveness of the transmission process if cash rates fell below 2 per cent. Typically, Australian banks protect their 'margins' at around 2 per cent. It would be extremely difficult for banks to maintain that margin and cut loan rates if more deposit rates had already reached zero.

If the Bank persisted with easing rates below 2 per cent the stimulus would work through weakness in the Australian dollar rather than private sector interest rates. We doubt whether the Bank would be prepared for their policy to be blunted with no pass through to private rates particularly given their spectacular success so far.

Readers will notice that we are not expecting to see rates rising before 2011. We do not expect that global growth will reach a sufficiently vibrant pace in 2010 to prompt central banks to start withdrawing the huge monetary stimulus. Nevertheless, central banks like the RBA will be restless and nervous about maintaining such a policy stance.

However, we do warn that when central banks see the need to start taking back the current stimulus they will move swiftly to a neutral stance. For Australia that would involve rates moving fairly quickly. We assess that in addition to the lax regulatory environment in the US the biggest single cause of the current economic chaos was the decision by the US Fed to hold rates at 1 per cent for more than a year from July 2003. When the stimulus was taken back it was clearly signalled that it would be at a pedestrian pace of 25 basis points per FOMC meeting. Markets could operate in full knowledge that rate increases would be modest and predictable. That policy fuelled the housing excesses during the 2003–2006 period as economic agents could operate with full knowledge that the Fed would not be spoiling the party.

Bill Evans is the chief economist at Westpac.

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