Reserve Bank's Bold Move will not be the last
The Reserve Bank surprised markets recently by cutting the cash rate.
The size of the recent move certainly highlights the gravity of the current global crisis but it emphasises the flexibility which Australia has to deal with the global crisis. Australian rates are still near global highs giving the authorities plenty of scope to use monetary policy to offset the contractionary pressures of the credit crisis. As exemplified by Westpac’s passing on the recent 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 will be given another chance to support policy when we see the next stage of global cuts in the very near future.
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 today's 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 2½% to 3% 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% than a target level for the cash rate.
Wholesale borrowing costs (about half the borrowings of the banks) are more than 1% 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%, 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% or less for the official cash rate.
The monetary policy lever is being used to try to successfully navigate the Australian economy through the credit crisis. The other huge advantage which Australia enjoys over other advanced economies is our formidable accumulation of fiscal surpluses. It is also time for the fiscal authorities to accelerate plans to lead the rebuilding of Australia’s infrastructure. The credit crisis will constrain the capacity of the private sector to play the complementary role which may have been envisaged a year ago. The property and employment downturns are rapidly depleting the capacity of the state governments. The need for short term stimulus is here; under investment by the government sector has persisted for decades. The Reserve Bank’s bold move on monetary policy should be matched with a more urgent approach to infrastructure investment.
Bill Evans, Chief Economist
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