The Australian Financial Review
www.afr.com • Wednesday 20 August 2008

Lower interest firms up as a sure bet

Comment
Alan Mitchell
Economics editor

The Reserve Bank of Australia is gearing up to cut interest rates because the global credit crunch has increased the downside risks to its already low growth forecast for the Australian economy.
The RBA's latest forecast is for the non-farm economy to slow to a growth rate of just 1.5 per cent in 2008 and then accelerate slowly through 2009.
But, as the RBA says in its August board minutes, the commercial banks' high lending rates and credit rationing threaten to create a "deeper and more persistent slowing of the economy" than is required to bring inflation back to target A cut in the official cash rate at the September board meeting was publicly all but set in stone last week when the RBA's deputy governor, Ric Battelino, said the central bank was in a position to "respond on interest rates".
The money market is looking for a cut in the Dear term of at least 0.5 of a percentage point, and it would be surprising if it was disappointed
The most likely scenario is a cut of 0.25 of a percentage point in September followed by a further 0.25 of a percentage point cut in October.
A further cut also looks like a pretty good bet, but that and any subsequent cuts will depend on what happens to the economy and the financial conditions.
The RBA is trying to manage the economy as it is pulled in opposite directions by two powerful forces.
While the credit crunch and tight monetary policy are working to slow the economy, coal and iron ore prices have sent the terms of trade soaring. This, as the bank says, will add substantially to national income and the capacity of businesses, households and governments to spend
High inflation and the stimulus from the terms of trade are placing a limit on the extent to which the RBA can safely cut rates. In fact, the RBA makes it clear that the board delayed cutting interest rates in August because of its fear of a wages breakout.
Underlying inflation has been above the RBA's 2 to 3 per cent target range for the best part of a year, and it has been running at an annual rate of more than 4 per cent for six months. The risk, as the bank: explains, is that the high inflation rate starts to affect wage setting. If that occurred, the cost of reducing inflation later would be greater.
The RBA board chose to leave the monetary thumb screws on the economy for another month.
The other factor that should limit the extent of the cut in official interest rates, at least in the near term; is the behaviour of the commercial banks.
It is now likely that the banks will pass most of the cuts in the official cash rate OD to their customers. This, of course, was not always so clearly the case. In fact there was talk of further increases in bank lending rates in line with the cost of bank finance.
However, the government has put the banks under considerable political pressure, and the expectation of a cut in the official cash rate has flowed through to market rates such as the 90-day bank bill rate.
 In the past two weeks, the bill rate has fallen 0.5 of a percentage point, taking some of the pressure off the banks and making it possible for them to follow the RBA down.
That, in turn, reduces the size of the cut in the official cash rate needed to keep the economy on track.