Wednesday, November 19, 2008

But wait there's more - 0.75%, and then more

THE Reserve Bank board will cut Australian interest rates by at least 0.75 percentage points when it next meets in two weeks' time, and may cut by 1.00 points.

The minutes of the board's Melbourne Cup day meeting show that it rejected a recommendation from officials to cut by 0.50 points and instead cut by 0.75 amid alarm about "confidence among consumers and businesses".

Board members including the Governor Glenn Stevens, the Treasury Secretary Ken Henry and ANU economic modeler Warwick McKibbin were especially concerned about the erosion of household wealth.

The rout on share markets and the downwards drift in house prices had cut household wealth by 8 per cent in the 9 months to September. Board members feared that subsequent slides in share prices had made the slide greater.

"Members noted that there were few precedents for the current developments in household wealth," the minutes record...

After presenting the board with the staff recommendation for a cut in the cash rate of 0.50 points the Governor suggested that the members consider a choice between 0.50 points and 0.75.

They opted for the bigger cut in order to bring about "a further meaningful reduction in rates paid by borrowers and assist confidence among consumers and businesses". The aim was to bring rates "quickly to a neutral position".

The Reserve Bank has traditionally regarded the "neutral" cash rate as between 5.50% to 6.00%. This is the rate at which the Bank would be neither stimulating economic activity nor winding it back in. But bank officials believe that the neutral rate is now lower than that as a result of recent decisions by retail banks not to fully pass on cuts in the cash rate.

This would mean that the Melbourne Cup day cut to 5.25% only brought the cash rate back to neutral and perhaps did not quite do that.

Given that there is a clear need for interest rates to stimulate the economy at the moment, it suggests a need for a further big cut in December, with 0.50 points regarded as the bedrock and a cut of 0.75 points regarded as more likely.

Should economic conditions deteriorate further, and especially if the United States is declared in recession during the next fortnight a bigger cut of 1.00 points is likely.

Governor Glenn Stevens will expand on this thinking about rates in a closely watched speech to be delivered to the Committee for the Economic Development of Australia in Melbourne tonight.

A further cut of 1.00 points if fully passed on would cut the standard bank variable mortgage rate from around 7.7% to 6.7%, cutting the repayments on a $300,000 mortgage by an extra $200 per month. Monthly repayments would have dropped $570 from when mortgage rates peaked at 9.6% in August.

Although the Reserve Bank board is not due to meet again after December until February, the Governor Stevens stands ready to call an emergency meeting in January to deliver a further cut if needed. In January the Bank will have an indication of whether the $8.7 billion of stimulus payments due to be deposited into bank accounts from December 8 boosted economic activity or were largely saved.

The Bank has called unscheduled meetings in January twice before; in 1990 and 1992 - in both cases to deliver an emergency rate of 1.00 points.

Late yesterday the futures market was pricing in a cut of 1.00% in December and a further 0.75% in February with further cuts taking the cash rate to a low of 3.25% in May - its lowest level since the 1950s.