The Reserve Bank has left the way open for a cut in interest rates should financial market conditions worsen.

The minutes of the 4 March RBA meeting (released at 11.30 this morning), which resulted in a 0.25% rate rise, reveal that the board was sufficiently concerned, even before the latest problems on Wall St, to introduce the idea of “adequate flexibility” to its policy considerations.

The minutes conclude by stating: “They (the board members) judged that the higher setting of the cash rate would leave adequate flexibility to respond as necessary over the months ahead to new information about prospects for economic activity and inflation”.

That’s a departure from the concluding statement from the RBA’s February minutes: “(The) Board would continue to review whether policy was sufficiently restrictive to return inflation to the 2–3 per cent target within a reasonable period.”

The difference between the minutes and the board statement published on March 4 backs up the feeling that the RBA had decided not to be as hawkish on rates as it had been in February when it raised rates and issued a toughly-worded Monetary Policy Statement which forecast high rates and inflation until the middle of 2010.

This is despite the fact the RBA now expects our terms of trade to have increased by 10% to 15% by mid-year due to higher prices for commodities like iron ore, coal, wheat, oil and metals. It had previously estimated the improvement at around 5%, perhaps a bit more.

The bank pointed to the “substantial tightening” in monetary conditions in recent months:

In judging the appropriate extent of further tightening, members also recognised that developments in financial markets in recent months, both overseas and in Australia, had increased funding costs for intermediaries by more than the effects of past and expected future policy changes.

Prior to the meeting, 90-day market yields on private paper had reached around 8 per cent, up by about 150 basis points since the middle of 2007. Rates for borrowers from intermediaries were likely to rise by more than any increase in the cash rate, reflecting these higher funding costs.

Members also noted the possibility of non-price tightening of credit terms, which, if it occurred, would add to the restraint imposed by higher interest rates.”

On balance, members concluded that a further 25 basis point rise in the cash rate was necessary to restrain demand, in order to reduce inflation over time.

As a result of this decision and earlier policy adjustments, and rises in borrowing costs that were occurring independently of changes in monetary policy, members saw the overall tightening in financial conditions since the middle of 2007 as substantial.

So it’s against those comments that there’s been a substantial drop in short term money markets rates which, if sustained, will take the pressure of banks to further boost their lending rates in excess of any RBA move.

This drop has been engineered by the RBA keeping the money markets well cashed up and by leaving as much money in its Exchange Settlement Accounts as it did in the early days of January when conditions were very tight.

Such have been the size of the falls in yields on 90 and 180 bank bills in the past week that they should obviate the need for any further increase from the banks, even if the RBA doesn’t move, as most economists now predict.

Yields for 90 day bills yesterday were 7.77%, down 0.35% from the peak of 8.12% on March 10, and under the 7.96% on March 4 when the RBA lifted rates 0.25%.

Yields on 180 day bank bills were 7.91% yesterday, compared to 8.25% on March 10 and 8.15% on March 4. That’s a fall of 0.34%. Yields are now at their lowest point for a month.

The amounts left in the ESA have been above $3.5 billion, while the bank has been injecting enough funds each day through its market operations via repurchase deals, to keep the cash rate comfortably at the 7.25% range.

This downturn will ease pressures in our markets and on our banks. It means we are not as worried about the immediate future as the US where yields on three month Treasury Notes hit a low of 0.635% at one stage yesterday, the lowest since the early 1950s and yields on two year bonds hit 1%.