Will the global market crisis force the Reserve Bank to perform a U-turn?

This is the big question for policy this week and this month in Australia, and elsewhere.

There’s a real possibility that the RBA got it wrong when it raised rates last week. Henry has been consistently calling for rate hikes to slow an inflationary economy. But writing last weekend, Henry said the case for a rate hike was strong, unless…

The “unless” was an important and explicit caveat and concerned the state of global markets:

Apart from inflation, the US ‘sub-prime’ lending crisis is the major current cause for concern for the global economy. Its ripples are still spreading and in the past two weeks these ripples have produced a substantial equity market correction in most markets. Until Friday the correction in Australia’s market was around 8% from the recent peak, but Wall Street’s ugly Friday trading is almost certain to increase the size of the correction at the start of this week.

Another bear point in the current global outlook is the price of oil, which has been steadily rising for some time now after the welcome drop in the lead up to the Northern summer. The upturn in the price of oil and of many other commodities is a clear manifestation of global inflation on the rise. Equity markets have become inured to the effects of dear oil, but more thoughtful investors have quietly factored inflation and the accompanying increase in global interest rates into their calculations.

The Reserve was unlucky in the timing last week. At the time of its board meeting global markets had seemed to settle. Although it seemed that volatility would rule markets for some time, ugly falls did not occur on Monday night, during Tuesday in Asia or in the US on Tuesday night our time.

Late last week, news that a European bank’s funds had been badly hit by the ripples from sub-prime loans gave a bad jolt to confidence, and led the European Central Bank and the US Fed to pour liquidity into financial markets to limit panic-induced rises in short-term interest rates. Late on Friday we learned that the RBA had also injected liquidity into our markets.

There is no easy answer to the question of whether the RBA (and other central banks) will reverse engines on monetary policy.

If the ripples from the sub-prime lending crisis turn into large waves there will be no choice. Modern central banks will always try to avoid adding a liquidity crisis to a crisis of confidence, and therefore making the crisis of confidence much worse. That was the reason for Henry’s “unless” last weekend.

So readers need to watch markets carefully this week. Substantial volatility with no trend, or a gently falling trend, will leave monetary policy where it is.

Growing volatility with substantial further falls in market values will mean cuts to official rates, and the first such decision is likely by Chairman Ben Bernanke of the US Fed.

Read more at  Henry Thornton