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Wednesday, September 17, 2008

Lehman changes everything...

...for Australia's Reserve Bank

An interest rate cut at the next Reserve Bank board meeting on October 7 is now a live possibility as a result of the collapse of Lehman Brothers in the United States.

The minutes of the Bank’s most recent board meeting on September 2 released yesterday contain no hint that there would be a follow-up cut. They say the decision to cut in September was reached on “balance” after weighing up “opposing forces confronting the domestic economy”.

The collapse of Lehman Brothers, the fire sale of Merrill Lynch, and an impending worldwide shortage of capital have dramatically changed that landscape.

The Bank believes that four risks have grown since the weekend.

One is that money will become hard to get as international investors shut their wallets...

In the first two days of this week the Bank has spent around $4 billion buying bank securities for cash in order to ensure that they have ready access to it.

Its September minutes express concern about the rising cost of funds in financial markets and indicate that was one of the factors that persuaded it to cut its cash rate. Those costs are likely to rise much higher.

Another risk is that the US will slide into recession, dragging down the world economy and commodity prices with it. That would slow the Australian economy and ease any risk of resurgent inflation.

There is also a risk that Australians will feel much poorer and wind back their spending in the wake of the slide in our share market. The Australian market slid 1.5% on Monday and a further 1.4% on Tuesday.

And there is the risk that Australian banks are themselves exposed to Lehman Brothers. In parliament Prime Minister Rudd described that exposure as “modest”. Westpac said that its exposure was less than A$10 million.

But Mr Rudd said it was important to acknowledge that Australia was part of the global financial system and “therefore not immune”.

The Prime Minister and the Treasurer were by the Reserve Bank Governor Glenn Stevens and the head of the Treasury Ken Henry Tuesday morning.

The futures markets yesterday pushed up further the implied probably of an October interest rate cut, pricing in a greater than 100% chance of a cut of 0.25 percentage points. This suggests that the market believes there’s a chance that the Bank will cut by more than 0.25 points on October 7.

The Bank last cut interest rates by more than 0.25 points in April 2001 when it cut by 0.50 percentage points in a successful effort to prevent Australia falling into the recession that awaited the US.

It was due to get an idea of how seriously US authorities viewed the crisis at 4.15 this morning when the Federal Reserve US revealed whether its Open Market Committee had decided to cut US rates. A decision by the Fed to cut its federal funds rate by 0.50 percentage points to 1.5% would be seen as a sign that it was very worried.

The Reserve Bank’s Governor Glenn Stevens will have an opportunity to outline his reaction to developments in the US at a previously scheduled speech at lunchtime today.