RBA To Cut Cash Rate 50bp On 7 April

RBA To Cut Cash Rate 50bp On 7 April; Terminal Rate Forecast Now 2.5%

Australia's Reserve Bank Board next meets in Brisbane on 7 April. We now expect a 50bp rate cut; previously, we thought RBA officials would wait until mid-year before cutting the cash rate again. In the wake of more grim news on the global economy and evidence that the RBA's decision on 3 March to leave the cash rate steady was a closer call than it first appeared, we now believe the case in favour of an earlier move has become more compelling. That said, with uncertainty about the economic outlook still high, the April decision also is likely to be a close call. In addition, we have lowered our forecast for the terminal cash rate 25bp to 2.5% on the assumption that the RBA also will cut the cash rate again in May, albeit more modestly than in April.

Our previous forecast that the RBA would wait until mid-year before easing again was based on the premise that RBA officials wanted more time to assess the impact on the economy of the significant monetary and fiscal stimulus delivered in recent months. With another round of welfare payments to low and middle income earners paid only this month, and the RBA's earlier rate cuts still flowing through, our view was that prudent assessment of the impact of these measures would take months, not weeks. A more problematic outlook for the global economy, though, and signs that the performance of Australia's economy rapidly is coming back to the pack, mean waiting for more information has become a luxury RBA officials no longer can afford.

Having decided to pause in March, the RBA Board effectively established a high tolerance threshold for bad news. Collapsing demand for commodities in our major trading partners, for example, and widespread announcements of job losses in Australia, apparently were not serious enough to justify another rate cut. To be fair, the 400bp of rate cuts already delivered to some extent pre-empted the emergence of bad news. In hindsight, though, it seems now that, instead of being unreasonably tolerant, Board members simply had made a tactical decision to go "on hold", and used the "need more time" argument as a convenient excuse. This decision was designed partly to overturn market expectations for rate cuts after each and every Board meeting.

So what information since the March Board meeting prompted our forecast change? First, the minutes of the March meeting released last week showed that the decision was a much closer call than we were led to believe. Officials saw merit both in cutting the cash rate and in holding fire; this came as a surprise - the policy announcement two weeks earlier had suggested the decision to keep the cash rate steady at 3.25% was relatively straight-forward. The revelation in the Board minutes that the March decision instead was line-ball meant that each subsequent meeting was "live", particularly given the blizzard of bad news from offshore. The penny dropped that the pause we originally thought would last for months could, in fact, last only a few weeks.

Second, there has been plenty of worrying news on the global economy since the last Board meeting, suggesting the RBA's "tolerance" is being tested. Until the March policy announcement, when officials seemed to use Australia's relative outperformance as another "excuse" to leave the cash rate steady, developments offshore had been the main driver of RBA policy. For example, Japan, Australia's largest export partner, has slipped even deeper into recession. Similarly, the IMF recently downgraded its growth forecasts for the world economy to include recession, something likely to ring alarm bells for some RBA Board members. Also, there is speculation that the recent coal price negotiations showed new contract prices for our largest export commodity below our already cautious expectations - this will punch an even larger hole in Australia's already falling terms of trade.

Third, conditions in financial markets are troubling enough to justify the US Fed announcing a program of Treasury purchases in large quantities, and other central banks are engaging in varying degrees of quantitative easing - these are important developments for the RBA policy outlook. One interpretation is that, with key central banks "on the case", the RBA's job of supporting growth in Australia may be complete. We believe, though, that RBA Board members will interpret bold actions by other central banks as evidence that global financial markets remain dysfunctional, rather than a opportunity to let others do a disproportionate share of the heavy lifting.

Fourth, there now is no doubt that Australia is in recession, the first since the early 1990s. Even Government officials now admit that recession here is inevitable. This week, we downgraded expected "growth" in Australia's economy for 2009 to -1.2%, the deepest contraction since 1991, from our previous forecast of -0.7%. The economy contracted 0.5%q/q in 4Q08 - our forecast is that the contraction in 1Q09 will be at least twice as bad, and that the economy also will shrink in 2Q. Previously, we believed the recession would last "only" two quarters. Moreover, our forecast is that the eventual rebound from recession this time will be unimpressive, partly because the necessary deleveraging of the household sector is far from complete.

The main trigger for our downgrade to Australia's expected GDP growth was the downward revision to expected growth in Japan, which signals that Australia's exports will sink even more this year. This has significant negative multiplier effects for capital spending and employment. Indeed, with the recession getting deeper, our forecast for the jobless rate touching 9% next year now looks a little low. On this, there have been even more announcements of significant job losses in Australia since the last RBA Board meeting, including in sectors as diverse as manufacturing, the law, retailing and even government administration. The RBA almost certainly will have downgraded the staff forecast for GDP growth, and pushed up the forecast for unemployment.

On the flipside, however, there are credible arguments in favour of the RBA staying on hold in April. Risky asset markets have improved in recent weeks, which means the wealth destruction partly to blame for rising consumer pessimism has stopped. Similarly, the sharp rebound in activity by first home buyers, admittedly triggered almost exclusively by the expanded first home owners' grant, suggest the established housing market has found something of a floor, although starts remain in free-fall. Also, the Federal Budget in May almost certainly will include another round of fiscal stimulus, including an increase in the aged pension, bonus payments for the unemployed, and even more funding for infrastructure.

Moreover, there is a case to be made that the RBA should preserve policy ammunition for a later day. To be sure, it will be difficult for officials to stand idle on policy as the unemployment rate soars towards double figures, so it makes sense to keep something in reserve. RBA Governor Glenn Stevens, however, has hinted that waiting often results in more ammunition being expended than would otherwise have been the case. Even with a cash rate as low as 2.5%, the RBA will retain plenty of policy ammunition, particularly relative to other central banks, some of which already have moved to ZIRP.

We, therefore, discount the "keeping powder dry" argument - if there is a case for lowering the cash rate, it is best to stay ahead of the curve by acting preemptively. Indeed, easing too much, too soon still is a "mistake" RBA officials are more inclined to make.

ENDS

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