Expecting A 50-Basis Point Australian Rate Cut Tuesday

October 6, 2008

While global financial markets spin further and further into very dangerous territory, the Reserve Bank of Australia Policy Board prepares to announce a rate reduction at 14:30 AEDT (03:30 GMT) on Tuesday.  Under the circumstances, a reduction of greater than 50 basis points makes more sense than a cautions move of just 25 basis points.  Most likely, officials will settle for a 50-basis point compromise, constrained in part by a free-falling Australian dollar.  On September 2nd, the Board cut rates for the first time since 2001, released a less dovish statement than hoped, and left markets pricing in only 25 basis points of further relief in 2008 and just 50 bps by September 2009.

With hindsight, it appears increasingly clear that central banks and governments did not take a sufficiently preventive stance against worst-case scenarios of the 14-month long global credit crunch.  The insistence by various authorities that anti-inflationary monetary policy be kept separate from daily efforts to liquify money markets has also been exposed as ill-conceived, since the system’s rupture reflects deficient solvency more than insufficient liquidity.  Only the Fed had cut rates sharply by March of this year, but neither that support nor a big U.S. fiscal stimulus in 2Q08 is preventing the U.S. from careening into recession.  Other major central banks, including the Reserve Bank of Australia, made two costly misjudgments.  The first was not to appreciate how far the credit crisis would spiral out of control, and the other was to mistakenly assume their economies would be insulated from the banking calamity and be adequately supported by opposing upward forces on growth.  Australia was one of several economies that would be buoyed by resilient emerging market demand.  Australia would also benefit from a large jump in the terms of trade (economist jargon for export/import price ratio) and from further tax cuts.

The statement of September 2nd addressed the issue of excessive inflation first and only turned to the matter of difficult financial markets in the second major paragraph. Inflation was not forecast to settle below the 3% target ceiling until 2010, and additional relaxation of the “restrictive” monetary policy was to be contingent on the assessment of future demand and inflation.  Officials in early September did not foresee the string of U.S. and European banking failures, nor the extraordinary liquidity-injecting actions that would be required by them and other central banks around the world.  They had no crystal ball to indicate that oil prices would be more than 23% lower when they would be meeting in October or that the Australian dollar would plunge 16%.  In a normal recession, inflation may retreat only temporarily, but crushing, credit-driven global downturns in the past have overwhelmed any latent inflationary forces. There is little reason to expect this business cycle to be any different.  The market reaction to last Thursday’s ECB decision not to cut rates immediately demonstrates how fearful investors have become and that continuing policy inertia risks inflaming the fast-degenerating situation.

The Reserve Bank of Australia has a long way to cut its 7.0% cash rate before the stance becomes neutral.  In these critical times for all financial markets, not enough time exists to attack the problem in increments of 25 basis points per month, especially considering that only two additional meetings are scheduled before early February.   A cut of more than 50 basis points would thrust Australia into a lead role in reversing monetary policy and would shed some light on whether deep and coordinated interest rate reductions by many central banks is a policy tool whose time has come.  In the end, I expect the Reserve Bank not to take on the role of test case.  The next full quarterly review of the outlook for growth and inflation is scheduled for November.  It will be tempting to stay with the parameters of market expectations (25-50 bps) and delay any thought of a bigger move until that review.



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