WEEKEND ECONOMIST: The world turns
The surprise move from the RBA to cut rates by 100bps marks the beginning of a more aggressive rate cutting cycle which will reach its nadir on 2009 before moving to tighten in 2010.
As exemplified by Westpac’s passing on of a 0.8 rate cut for variable mortgages, Australian banks are profitable and strongly capitalised and are in the position to support monetary policy – unlike the responses we saw from the UK and US banks when their central banks cut rates last year. Those banks are now being given another chance to support monetary policy but we expect that there will be little impact on mortgage rates.
The most important reason given by the RBA is the significant deterioration in global financial markets. Furthermore, the Governor says "financing is likely to be difficult around the world for some time ahead”. The second most important reason given was a substantial revision to the Bank’s view about the growth outlook for Asia – that is now being described as having seen a "significant moderation” and the terms of trade are now confidently predicted to fall, with global inflation also likely to moderate. With these two factors in place, the Bank is taking a forward looking approach to growth and inflation risks in Australia. They refer to "the risk that demand and output could be significantly weaker than earlier expected ... inflation would most likely fall faster than earlier forecast”.
The conclusion by the Bank is that a "significantly less restrictive stance of monetary policy” was required. I believe this terminology is important because one can reasonably conclude that the Bank believes that policy will still be restrictive after the October move. In previous easing cycles, which have been associated with much less threatening global and domestic economic risks, the Bank has chosen to move to a neutral/expansionary stance within one year, with cuts of 200 to 250bp in total. In those earlier periods, inflation was contained, being in the 2.5 to 3 per cent range.
However in those episodes there were no risks associated with the functioning of the financial system either domestically or globally, or the genuine prospect of a global recession. The Bank has now clearly enunciated its position that a sharp downturn in demand conditions will ensure that inflation declines. Consequently, we expect that this cycle will be more aggressive than the previous two, where it took around a year to move back to neutral. The level of the RBA cash rate that equates with neutral will be determined by the degree to which the banks pass on the RBA rate cuts. Policy is likely to be determined more by the need to get the variable mortgage rate down by 2 per cent than a target level for the cash rate.
Westpac’s decision to cut the variable mortgage rate by 0.8 per cent following last month’s 0.25 per cent cut means that in terms of the mortgage rate we are more than half way there. But progress in achieving the additional 1 per cent cut might be more difficult. Wholesale borrowing costs (about half the borrowings of the banks) are more than 1 per cent higher than before the crisis began. Retail borrowing costs have also tightened significantly as the smaller institutions that are now denied access to funding in global markets pressure domestic funding costs. A test of whether we can expect further bold moves from the banks will be the degree to which they are able to manage down retail deposit rates. Banks are intermediaries. They can hardly be expected to aggressively cut lending rates if deposit rates do not also fall.
For a full pass-through, the neutral cash rate would be around 5.5 per cent, but we expect that with the credit crisis almost certain to persist for the next six months at least, neutral is much more likely to be 5 per cent for the official cash rate. The Bank is now likely to set its objective to move policy into the expansionary range which we think will be defined as 5 per cent on the cash rate or below. That suggests to us that we can expect another 150bps in total of RBA rate cuts within the next three to six months. Recent cuts are likely to continue in November and December with 50bp moves in both months.
These developments have also prompted us to review our core approach to the current policy cycle. Because of the need to address the inflation challenge while simultaneously dealing with the credit crisis we thought the Bank would have to adopt a very difficult and dangerous balancing act. That was to "manage” growth prospects back to a growth profile of around the 2 per cent the Bank envisaged as necessary to gradually bring down inflation. That would entail two stages of the easing cycle. The first to deal with the credit crisis by bringing rates down but keeping them well in "contractionary territory” followed by a pause and the second to bring rates below neutral once inflation was seen to be moving towards the 2–3 per cent range.
Developments in global credit and equity markets which are now destroying confidence (Westpac Consumer Sentiment Index down by 11 per cent) and wealth (Australian share index now at its lowest level since June 2005) will prompt a decision by the Bank to aim to move quickly into expansionary range. We expect rates to be there by early 2009.
That profile will change our rate outlook during the second half of 2009 and 2010. Yield curves are likely to steepen from the middle of 2009 as markets anticipate economic recovery and the eventual beginning of a new tightening cycle. Whereas we expected 2010 to be a year featuring the second round of this extended rate cuts it will now likely see both RBA and US Federal Reserve moving to tighten rates.
US rates will be moving from a much lower base than Australia. Just as we saw Japanese authorities reduce their cash rates to zero in the Japanese banking crisis of the 1990’s so the Federal Reserve will move to 0.5 per cent in the first half of 2009. Both the RBA and Fed will be taking back their accommodation during 2010.
Bill Evans is chief economist at Westpac