WEEKEND ECONOMIST:New base for rates

Many still believe that the RBA needs to keep some rate-cutting capacity in reserve, though there is growing acceptance that an official cash rate below 2 per cent is a distinct possibility.

The RBA announced a 25bps cut following the Board meeting on Tuesday. Westpac had consistently argued that the RBA was likely to keep rates on hold for a number of months to assess the impact of the recent aggressive rate cuts and substantial fiscal stimulus packages which are being implemented by the government. The other argument in favour of a pause was to allow the RBA to conserve some flexibility to deal with potential further shocks, both domestic and international, over the course of 2009.

In moving to cut by a further 25bps the Bank has reacted to two significant issues. The first one appears to have been the release of revised world growth forecasts by the OECD which painted a decidedly darker picture of global prospects than had been the consensus. In this regard, the statement notes "most assessments of the near-term outlook have been further marked down". We have had a more pessimistic view of world growth than consensus but now find the OECD estimates too pessimistic. We forecast OECD growth of –3 per cent in 2009 compared to the OECD's forecast of –4.3 per cent.

As has been the case in the past, the international agencies are sometimes slow to identify major issues and can then belatedly overshoot on some forecasts. We expect this forecast by the OECD will be no exception. If we are right then the RBA is unlikely to receive yet further global news to require another global growth downgrade over the next few months, taking some pressure off the need to move on rates again in the near term.

The second significant issue has been a lowering of the domestic growth outlook to formally include a recession. The statement notes "The Australian economy is contracting". Previously the RBA was forecasting flat growth in 2009. Westpac has been forecasting negative growth in 2009 since early January and we suspect that the Bank would have seen all the risks to be in that direction since about that time as well. Consequently we assess that the most important driver of this decision has been the global growth view.

The future path of rates depends on whether you adopt a view that the RBA has decided that the 'pause' approach which we saw in March has been jettisoned to get continuous stimulus into the system as early as possible, or whether they still see the attraction of holding back some flexibility to be able to deal with future shocks – either global or domestic.

We still favour the latter approach and hence expect there will be an extended pause until around August before we see another move, which is likely to be a cut of 50bps.

Despite market pricing consistently indicating a low point in this cycle of 2.5 per cent we are sticking with our view that rates will eventually bottom out at 2 per cent or lower. Our most likely low point target of 2 per cent has been predicated on the view that the banks would be constrained in their ability to pass on any further cuts to mortgage rates if official rates go below 2 per cent. The reaction of the banks to this latest 25bps cut clouds this issue. Three banks passed on a less than expected 10bps and one passed on zero. Markets might start to interpret those actions as indicating that the point at which banks decide not to pass on any further rate cuts is nearer than we had anticipated.

On the other hand it may be that banks will be able to sustain modest rate cuts for longer than we had originally expected. That possibility leaves the window open for the low point in the cash rate to go below our 2 per cent target.

Mortgages now represent more than 50 per cent of banks' assets. Business loans represent most of the rest with a small proportion in personal loans including credit cards and margin loans. The liabilities of banks are dominated by domestic and offshore wholesale liabilities; retail deposits (including non interest bearing) and capital/float. Pricing of the wholesale liabilities tends to move with the bank bill curve while NIB/capital/float are interest free (expected return on capital will however be affected by the overall interest rate environment). Retail deposit rates will be partly affected by market rates although other issues will always distort this relationship. For example we estimate that since the RBA has cut the cash rate by 425bps the banks have cut the prime variable mortgage rate by around 375bps while retail deposit rates have only fallen by around 200–250bps.

In particular, banks are attempting to lower their reliance on offshore wholesale funding given the uncertainties and rising costs which have resulted from the global financial crisis. That emphasis on retail deposits as a more stable source of funding has been the key driver behind the resilience of retail deposit rates. This policy stance has undoubtedly been benefitting household depositors with deposit rates not falling as much as would have normally been expected from the aggressive easing by the RBA.

In particular if this trend of resilience of retail deposit rates to official rate cuts continues it might be that retail deposit rates are still "competitive" even if the RBA has cut rates to as low as 2 per cent. That would give the banks greater scope to respond to rate cuts below 2 per cent since there would be scope to lower asset rates if there was some flexibility in the retail deposit space.

Certainly we expect that the RBA will be needing to be seen to be continuing to cut rates in the second half of 2009. The twelve month period is likely to see the sharpest increase in the unemployment rate. That period is also likely to be associated with a substantial slump in consumer confidence.

Following the release of the April Consumer Sentiment Index I noted, "Superficially, we should be encouraged that the average level of the Index over the last six months is higher than the average of the previous six months by 4.4 per cent. However it would be premature to argue that the Index has passed its lows in this cycle."

"We note that in the early stages of the last recession the Index also appeared to have recovered from its lows. The average for the six month period November 1989 – April 1990 was 4.3 per cent above the average for the previous six month period. However, the average for the following six month period plunged to 15.1 per cent below that level. That period coincided with the first half of the 12 month period when we saw the most rapid increase in the unemployment rate during the last recession when it increased from 5.9 per cent to 9.4 per cent.

"Given the disturbing signals from all the leading employment indicators which are pointing to a rapid increase in the unemployment rate over the next 18 months, we are likely to see the Index reaching new lows over that period."

During that recession the RBA cut rates from 18 per cent to 5.75 per cent over a two and a half year period between January 1990 and July 1992. In the period (March 1990 - April 1991) when the unemployment rate was increasing most rapidly it cut aggressively by 500bp's.

Retaining some flexibility for the equivalent period in this recession and even pushing rates lower than 2 per cent if policy is still getting traction from the banks seems to be an attractive option for the RBA.

Bill Evans is Westpac's global head of economics

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