Conventionally a 50 basis point cut in official interest rates ought to trigger alarm bells. Today it could just be evidence of the Reserve Bank’s relatively newfound pragmatism.
Moving the cash rate by something more than the usual 25 basis point increments is unusual. The last move of more than 25 basis points – and there were four successive moves of more than 25 basis points, three of them by full percentage points – was in the midst of the worst of the global financial crisis in late 2008 and early 2009.
In other words, in the past, anything more than 25 basis points was a signal that the RBA was truly concerned about the state of the economy.
It might well be today, even though domestic demand has been running at its fastest level for four years. Every day brings fresh news of company failures and job losses in the non-resource side of the economy. In the RBA’s own words, ”considerable structural change” is occurring within the economy. The continuing strength of the Australian dollar is exerting enormous pressure.
The RBA, however, has also been at pains over the past 12 months to make it clear that it uses the cash rate to target the actual rates borrowers will pay for their funds within a different environment to that which prevailed pre-crisis. Then the banks generally simply passed on the RBA’s decisions. Today they don’t.
Whenever a senior RBA official speaks publicly about monetary policy these days they make the point that, while they can influence the absolute level of interest rates within the economy, they can’t dictate the margin over the cash rate actually paid by the banks for their own funding.
As the RBA said today, while wholesale funding costs for the banks have been declining, they remain higher, relative to benchmark rates, than they were in the middle of last year. There has also been a fierce battle between the banks for domestic deposits as they try to reduce their reliance on offshore wholesale funding.
Going into today’s board meeting the RBA, whose staff maintains a continuous dialogue with the major banks, would have known that if it cut by 25 basis points the major banks would, in this new environment where the relationships between their funding costs and the cash rate has been de-linked, have retained 10 to 15 basis points of the reduction in the cash rate. A 25 basis point cut would end up as a 10 to 15 basis point reduction in lending rates and therefore be largely immaterial in terms of its impact on the real economy.
By opting for a 50 basis point cut the RBA has effectively ensured that it will probably get 35 basis points to flow through to borrowers, which would have a much more significant impact on the psychology of borrowers and their real interest costs. In the process it has practically invited the banks to hang onto some of the reduction.
One way to interpret the move would be to say that it indicates some concern by the RBA about the state of the economy but not the kind of fear that drove those percentage point reductions during the worst of the financial crisis. That might change if Wayne Swan actually delivers the $40 billion-plus contraction in the economy implied in his promise to bring the budget back into surplus.
The state of the world that informed the RBA’s decision is as it has been for some time. Global growth is weak, with the US producing anaemic growth off a very low base, Europe still on a knife edge and China in a controlled slowdown. Our terms of trade, while still high, are well off their peak but the Australian dollar remains at historically high levels.
Inflation is a non-issue – the March quarter numbers that cleared the way for today’s rate cut were weaker than anticipated and are running at the bottom of the RBA’s targeted range – and employment is softening.
House prices are still sliding and consumers and businesses are in defensive modes.
The RBA would also be well aware that the banks are unlikely to use the rate reduction to go on an orgy of lending – they are more interested in shoring up the funding side of their balance sheets than expanding their asset bases. That’s another reason why they won’t pass on the entire reduction – they have been very successful in attracting term deposits, whose cost they can’t change quickly.
With the cash rate now at 3.75 per cent the RBA has less room to manoeuvre if Swan does deliver his horror budget and it is greeted with horror by consumers and business, but it still has more scope to cut rates than almost any of the developed world’s central banks. During the original crisis, in April 2009, the cash rate got down to three per cent.
While politicians and borrowers love rate cuts, let’s hope we don’t see the cash rate at that level again because the bells would then be tolling very loudly.
This article first appeared on Business Spectator.