Monday, February 02, 2009

Why this board will cut 1.00 percentage points tomorrow, perhaps more

When the eight men and one woman who sit on the Reserve Bank board regroup after a two month break tomorrow they'll be considering not only how much to cut their cash rate (a further 1.00 percentage points is likely) but also how far it should eventually fall.

It's a question they've rarely had to consider. But at 4.25 per cent, the Bank's current cash rate is now equal to the lowest its ever been.

Every step down from here on establishes a new precedent; sets a new floor.

And there's a belief within the Bank that low floors are dangerous. When the United States cut its rate to a low of 1.00 per cent earlier this decade in order to lift itself out of recession it arguably sowed the seeds that helped create the sub-prime bubble whose bursting is now destroying economies worldwide.

Might 2.00 per cent be a good floor for Australia's cash rate? And if so, should the Bank move there quickly or take time?...

One argument that will be forcefully put at the boardroom table is that if Australian needs a new floor it may as well get it quickly, so as to create the maximum economic boost.

The counter-argument ("keeping the powder dry") is that if board delivers only some of what it thinks is needed tomorrow it will be in a better position to judge whether the rest is needed further down the track.

A cut of 1.00 percentage points tomorrow would take the cash rate from 4.25 per cent to 3.25, still above the likely eventual floor.

A cut of 1.50 points (for which there are precedents, in New Zealand last week, and in Australia in the lead-up to the last recession) would take our cash rate to 2.75 per cent, nearer the eventual floor and would have a bigger impact.

Tuesday's decision, unlike nearly all of the board's earlier decisions, will be genuinely made by the nine board members sitting around the table. In recent months the Governor Glenn Stevens has invited the meeting to think beyond approving the recommendation he presented to it, and in at least one case has presented it with an open recommendation.

The views of the board members such as the Treasury Secretary Ken Henry (who is busy helping draw up Kevin Rudd's economic stimulus plan) and the academic economist Warwick McKibbin (who thinks are so bad we need to halve the GST) will be fully aired.

Bank staff believe that although the government's $8.7 billion "cash splash" boosted consumer spending at the end of December and the start of January, the effect is fading.

Whether we are currently in a recession or merely a period of very slow growth, all of the new information from overseas since the November board meeting points to things getting worse.

Japan's industrial production fell a record 9.6 percent in December, Korea's GDP fell an extraordinary 4 per cent in the December quarter, China's economic growth is only half what it was, and below the level needed to stop Chinese workers slipping back into poverty, and the International Monetary Fund believes that the world (reportedly including Australia) is headed for recession.

Some of the graphs mailed out to Reserve Bank board members are apparently frightening.

And since they were sent out on Thursday, the United States has provided updated data for another one. It's GDP shrunk 3.8% in the December quarter.

Things are changing quickly, for the worse. This will be at the top of the board member's minds as the decide how low to take Australian rates, and how soon.