WEEKEND ECONOMIST: Room to cut

We were surprised to see that underlying inflation increased in the September quarter. With the March quarter printing 1.2 per cent and the June quarter printing 1.1 per cent we expected that the slowdown in the economy, which has been very clear through 2008, would have caused some further modest moderation in the underlying measure in the September quarter. In the event underlying inflation actually increased to 1.2 per cent from 1.1 per cent in June. That would have unnerved the Reserve Bank although it is reasonable to assess that inflation responds to slowing demand with a longer lag than the six months that may have been expected.

The Governor's speech on Tuesday set out the Reserve Bank's position that inflation would fall in 2009, so until the first print of 2009 inflation was available (April 22) the Bank would be 'free' to focus on policies to avert the recession rather than targeting inflation. That plan coincides with our own view of the policy schedule. We think the Bank will aim to bring rates marginally into the expansionary zone by the first quarter of 2009. The stance of policy will be determined by the level of the variable mortgage rate rather than the cash rate. With the banks having tightened mortgage rates by 50 basis points more than the net tightening of the RBA over the last two years the 'neutral' RBA rate will be 50 basis points less than previous assessments. We would assess the 'old' neutral at 5.5 per cent with the new neutral at 5 per cent. A target of 50 basis points below that 'new' neutral – 4.5 per cent – seems reasonable.

That would imply two 50 basis point cuts in November and December to be followed by two 25's in February and March next year. We believe this will be the 'best' policy and is not inconsistent with the previous two easing cycles in 1996/97 (250 basis points to 5 per cent over 12 months) and 2001 (200 basis points over 10 months to 4.25 per cent). Due to the greater urgency of the global credit crisis, this easing cycle should be more rapid. The 275 basis points would be achieved in a seven month period from September to March.

Markets are currently pricing in a 50 basis point cut on November 4 (yes, Melbourne Cup Day) when a large part of the market (Melbourne) has public holiday and the Sydney crowd has traditionally been in party mode. We expect the Bank will have to alter this arrangement next year because limited liquidity will risk an unanticipated market response to any 'surprise'. That 50 basis point cut, which is our view, has come back from the 75-100 basis point that had been priced in until last Friday. The risk is that the market takes even more out of the near term outlook. Since the last 100 basis point cut, when the market priced in that 75-100 basis point follow up, we have seen a number of relatively hawkish events.

These include the government's $10.4 billion fiscal package; the banks' unexpected 25 basis point rate cut; the RBA Minutes which emphasised that the 100 basis point move should not be interpreted as indicating a new policy approach; the Governor's comments that another credit disaster was unlikely to occur; the message in the Minutes that the original rate cut recommendation was only 50 basis points; and the fall in LIBOR from 4.8 per cent peak to 3.5 per cent on its way back to a normal 2.8 per cent.

These events all point to the risk that the next move could be only 25 basis points. We are not changing our call for 50 basis points because we believe that the best policy will be to move swiftly back into expansionary territory so monetary policy can complement fiscal policy in offsetting the undeniably potent impact of the global credit crisis.

Our research indicates that the wealth effect will be one potent way in which the crisis will directly impact the Australian economy. In recent years Australians have increased their exposure to market linked forms of savings (direct equities and superannuation). At the end of September 2007 (near the peak of the market) Australians had increased their holdings of equities and superannuation to 270 per cent of household disposable income. That has now fallen to 200 per cent today.

Estimates of spending behaviour indicate that for every $1 fall in the value of direct equity holdings households reduce spending by 9 cents; there are no estimates around for superannuation and we have assumed a conservative 5 cents.

On the assumption of a 25 per cent permanent fall in the share market and a 15 per cent fall in the value of superannuation we expect spending to fall by 2.7 per cent in 2009 as a result of wealth effects. To offset that fall we need a decent increase in household disposable income which would accommodate a 'normal' rise in household expenditure. Interest rate cuts are an important boost to household disposable income given that job losses and weaker wages growth will be an offsetting drag.

Our profile for monetary policy complemented by expected tax cuts will allow nominal household disposable income to grow by a 'healthy' 6 per cent. That would normally allow a 5-6 per cent growth rate in household spending. However with the wealth effect offsetting spending growth by 2.7 per cent we estimate household spending will grow by around 3 per cent in 2009.

The savings associated with the wedge between income and spending growth will accommodate the drag on wealth that households have experienced. Without the expansionary monetary and fiscal policy the collapse in consumer spending growth would be an unnecessary drag on growth.

In short, expansionary fiscal and monetary policy will be required to offset the growth drag from the credit crisis. One of the most potent sources of that drag is likely to be the wealth effect which will operate through equities and superannuation. Other drags on growth stemming from confidence, reintermediation and the flight of foreign capital will be a direct drag on business investment but that analysis is for another piece.

Bill Evans is the chief economist at Westpac.