Australia | Oct 07 2008
By Greg Peel
A week ago, in the face of global financial turmoil, economists were moving to suggest the Reserve Bank of Australia would cut by 50 basis points instead of the usual 25. The futures market was factoring in a better than 90% chance this would occur. However, not all economists were convinced. Economic data showed demand was falling in the broader economy, but there were still too many elements in play to suggest inflation was contained. A 25 point rate cut would have not surprised.
But the global financial situation took yet another turn for the worse this weekend, with Europe now in the frame. Economists began to believe 50 points was a certainty, and maybe even 75.
No one expected 100.
The RBA today cut the overnight cash rate to 6.00% from 7.00%. The last time the RBA cut by 100 points was in January 1992 when Australia was about to hit the depths of a recession. However, that cut was the fifth of such magnitude in succession from 11.5% in April 1991, and was part of the process that brought the cash rate down from 17.5% in 1990. The last time the RBA cut by more than 25 basis points was in 2001, and that was only 50 points.
It puts today’s cut into perspective.
When the US Federal Reserve cut by 50 basis points in August 2007 economists called it “shock and awe”. The Fed was later to cut twice by 75 points in early 2008. That makes this cut by the RBA more than just shock and awe in comparison.
“Conditions in international financial markets took a significant turn for the worse in September,” RBA governor Glenn Stevens writes in his accompanying statement.
“Large-scale financial failures in several major countries were accompanied by serious dislocation in interbank markets and heightened instability in other markets, including sharp falls in share prices. Official actions in a number of countries have been aimed at restoring stability, by adding to short-term liquidity and laying a foundation for longer-term recovery in the health of balance sheets. Nonetheless, financing is likely to be difficult around the world for some time ahead. This is also affecting Australia, albeit by less than in many other countries, given the relative strength of the local banking system.”
This, we all knew. What we didn’t know is how the RBA was going to perceive the inflation problem in the face of such turmoil. The clue lies in Asia, and Stevens notes “evidence is accumulating of a significant moderation in growth in Australia’s trading partners in Asia”. What this finally means is that Australia’s growing terms of trade – to date the RBA’s greatest culprit in terms of inflationary pressure – will not be growing anymore.
Stevens suggests the terms of trade will feel the effect of most recent price settlements as they continue to flow through the system, but thereafter will be a decline in line with declining commodity prices. Indeed, inflation itself will moderate in 2009, Stevens suggests. This marks a change from the RBA’s previous fear that inflation would not moderate until 2010.
In a case of a job well done, Stevens notes “Thus far, the overall path of economic activity in Australia appears to have been close to what the board had expected, with the needed moderation in demand occurring”. The next CPI will still probably register around 5%, he says, but thereafter it should fall. But 100 points is not the stuff of everything going to plan.
“The recent deterioration in prospects for global growth, together with much more difficult market conditions even for creditworthy borrowers, now present the risk that demand and output could be significantly weaker than earlier expected,” Stevens adds, noting that in such a situation inflation would fall earlier than forecast, implying no need for a high interest rate. “Given that background, the Board judged that a material change to the balance of risks surrounding the outlook had occurred, requiring a significantly less restrictive stance of monetary policy.”
And there’s the reason for your 100 points.
Throw in the above, taking “careful note of movements in funding costs in wholesale markets”, and the Board decided “that on this occasion this an unusually large movement in the cash rate was appropriate in order to bring about a significant reduction in costs to borrowers.”
Each month economists scour the governor’s statement accompanying an interest rate decision in order to gauge a sense of what might happen in the ensuing month. This time they need not bother:
“The Board does not, however, regard that movement as establishing a pattern for future decisions.”
In other words, don’t expect any more shock and awe in the short term. The RBA will continue to “assess”, and continue to target an inflation rate of 2-3%.
Governor Stevens did not indicate whether an interest rate cut of such magnitude was made in isolation, or whether the RBA has joined in what will prove a coordinated global effort. But to assume he has not been at least on the phone would be foolish.