The Reserve Bank has slashed its key cash rate by an historic 1% to a new level of 6% as it seeks to protect the Australian economy from a hard landing brought on by the international financial market turmoil. It was a decision that puts the weights on the banks to pass through as much as the increase as possible and not quibble. The cut takes rates back to where they were in August 2006. There’s every chance we will get further rate cuts in November and December if global financial and economic conditions continue to worsen.  The RBA last cut rates in May 1992 in a series of five 1% cuts in 13 months from May 1991. The RBA Governor, Glenn Stevens said in the post-meeting statement that the board wanted a larger than normal increase to bring about “significant reduction in costs to borrowers”. He also warned that that growth in demand and output could be weaker earlier than expected, which is a nice way of saying that the risks of a quicker than expected slowdown in the economy have risen.He said: “Conditions in international financial markets took a significant turn for the worse in September. ” “Large-scale financial failures in several major countries were accompanied by serious dislocation in interbank markets and heightened instability in other markets, including sharp falls in share prices.  “Official actions in a number of countries have been aimed at restoring stability, by adding to short-term liquidity and laying a foundation for longer-term recovery in the health of balance sheets.  Nonetheless, financing is likely to be difficult around the world for some time ahead.  “This is also affecting Australia, albeit by less than in many other countries, given the relative strength of the local banking system.” The move flies directly in the face of the long-held view in central banking that it’s best to work in small increments. In fact there’s something of an adage in central banking that the bigger the cut in interest rates, the greater the level of concern about the economy. Central bankers prefer to work in gradations of 0.25%, and even a 0.50% cut is big news and a decision not lightly made. US Fed Chairman, Ben Bernanke raised eyebrows earlier this year when he chopped the Federal Funds Rate by 0.75% a few weeks after cutting it by 0.25%. But the RBA’s cut is unprecedented among major central banks around the world. The cut, revealed this afternoon at 2.30 was made because there had been a “material change to the balance of risks surrounding the outlook had occurred, requiring a significantly less restrictive stance of monetary policy.

The bank made it clear that the huge cut, last seen in the early months of the 1991 recession, should be be seen “as establishing a pattern for future decisions.” It’s a clear one-off and should be seen so. But the RBA made it clear that it was looking to force as greater cut in interest rates into the wider economy as it could. The cut will force the banks to drop rates by up to 1%. The RBA has noticed the elevated rise in rates in short term markets, but clearly doesn’t see this as an impediment. “The Board also took careful note of movements in funding costs in wholesale markets. Having weighed these considerations, the Board decided that, on this occasion, an unusually large movement in the cash rate was appropriate in order to bring about a significant reduction in costs to borrowers. “Economic activity in the major countries is also weakening, and evidence is accumulating of a significant moderation in growth in Australia’s trading partners in Asia. The expansionary effects of the recent surge in Australia’s terms of trade are still coming through, but some decline in the terms of trade now looks likely over the coming year, with many commodity prices having declined from their peaks. This, combined with the likelihood of below-trend growth in the global economy, suggests that global inflation will moderate in 2009. 

“The recent deterioration in prospects for global growth, together with much more difficult market conditions even for creditworthy borrowers, now present the risk that demand and output could be significantly weaker than earlier expected. Should that occur, inflation would most likely fall faster than earlier forecast.

“The Board will continue to assess prospects for demand and inflation over the period ahead, and set monetary policy as needed to bring inflation back to the 2–3 per cent target over time.”

Read the RBA governor’s statement here.

Peter Fray

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