Tuesday, October 07, 2008

Going down: 50 points is just the beginning

Macquarie's Rory Robertson says "expect at least another 200"

Here's his note:

**My sense remains that overseeing a significant reduction in intermediary lending rates is fast becoming the Reserve Bank's policy priority. Today at 2.30pm, the RBA will cut its cash rate by 50bp (to 6.5%), if not more.

**With the US recession clearly deepening and global growth stalling under the weight of tightening financial conditions (the pessimists were right), the case for a bigger RBA cut (75bp or 100bp) today is stronger than the case for a smaller cut (25bp), in my opinion. That's notwithstanding the big drop in the A$ in the past week, alongside big drops in many other currencies against the US$.

**The RBA is beginning to cut aggressively because it has become more worried about (the risk of) recession and excessive unemployment than about excessive inflation...

Policymakers are increasingly confident that emerging economic weakness - sub-par GDP growth, rising unemployment and lower commodity prices - will kill, over time, earlier widespread inflation pressures.

**As observed here previously, now that domestic demand has slowed, and the global backdrop has deteriorated so markedly, headline mortgage rates above 9% and many business-lending rates above 10% are inconsistent with the RBA's desire for ongoing economic growth. If rates are not brought down by 1-2pp reasonably quickly, the Australian economy almost certainly will go into recession within 12-18 months.

**So, not only is the RBA set to cut by 50bp (or more) today, but it seems likely to cut by 50bp again in November and/or December. Actually, RBA staff might want to keep their plans for summer holidays tentative, as the need for an extra Board meeting in usually meeting-free January would not be surprising, given current deteriorating circumstances.

**Overall, my guess remains that the RBA's cash rate is on the way from 7% to 6% to 5% and towards 4%. Having spent some six years - from May 2002 to March 2008 - hiking rates by 3pp in total - to 7.25% from 4.25% - the RBA seems likely to cut its cash rate all the way back to 4.25% within two years. In part, that's because - with term-funding markets difficult to say the least - reductions in the cash rate over time are likely to be larger than the reductions in average lending rates they prompt.

**The debate locally about the extent to which major lenders will pass today's cash-rate cut into key lending rates generally misses the point that the RBA cares more about average lending rates than it cares about its cash rate, and will keep cutting the latter to deliver the desired level of the former. That is, the RBA's cash rate simply is the tool it uses to drive average lending rates. To the extent that lenders' (smaller) cuts leave average lending rates above the RBA's desired level, the RBA simply will cut its cash rate further.

**Naturally, existing borrowers want maximum rate relief, and they want it now. But, remember, there are two types of borrowers out there: existing borrowers and potential borrowers. The latter benefit only to the extent that lenders keep lending. In a global credit crunch, it matters a lot that lenders keep lending, because if the marginal borrower can't borrow, because the marginal lender won't lend, then marginal activity doesn't happen, and GDP growth stalls. For lenders to keep lending - rather than simply "hunker down", as in the US and UK - they need to remain profitable.

**Thus, to the extent that lenders "pocket" some of the benefits of lower funding costs (via the RBA's cash-rate cuts), existing borrowers can comfort themselves with two critical facts:

. there are more RBA cash-rate cuts and further lending-rate reductions in the pipeline; and

. with major lenders remaining profitable and continuing to lend, the economy - and particularly jobs growth - will be stronger than it would be if "credit rationing" became more severe.

Critics lining up to take an axe to the RBA

**As noted above, my sense is that the RBA's priority now is to manage lending rates significantly lower. Naturally, policymakers are very keen to avoid recession, for two main reasons. First, recession was never part of the RBA's plan. It always has been confident that a "soft landing" (1-2% GDP growth at the low point) would be sufficient to return inflation to its 2-3% target.

**Second, if the economy does eventually fall into recession, and unemployment rises to 6%, 7% or more, critics will line up to pin the blame on the RBA. The critics' strongest point will be that the RBA delivered the most-aggressive phase of its six-year tightening cycle after the global credit crunch began last August.

**That is, over the year to July this year, the RBA oversaw increases in key lending rates of 1.5-2pp, the largest increases in rates, and to their highest levels, in over a decade, despite growing stresses in global financial markets. The Board's minutes suggest that at least one member still was talking about the need for tighter policy as recently as May.

**With financial turmoil having intensified savagely in recent months, the outlook for local and global growth has deteriorated much more sharply than the RBA - and other central banks - had expected. When things turned nasty, the RBA was "caught with its rates up".

**RBA policymakers now will do what they can to avoid excessive rises in unemployment. That means managing key lending rates lower, with some urgency. And not worrying too much about the recent weakness of the A$, which may or may not be sustained; if it is, recession will be easier to avoid.

**The RBA's response to its growing chorus of critics might be to concede that it doesn't have perfect foresight: it did what it thought was right, given the facts at the time and its objective of keeping inflation low (while minimising unemployment).

**Indeed, it might even get on the front foot and highlight the fact that - to this point at least - unemployment - at 4.1% - still is lower than core inflation - at 4.3% ("trimmed mean" CPI) - which, in turn, remains way above the 2-3% target. That is, the latest hard data on inflation and unemployment emphasise the basis for the RBA's earlier policy tightening cycle. (Is unemployment lower than core inflation anywhere else in the world?)

**In any case, to the extent that the RBA now believes recession is an increasingly serious risk, it will lower rates with some urgency, to limit any tendency towards excessive unemployment.