Lucky Country Gambles On All Or Nothing

Sydney Morning Herald

Wednesday October 8, 2008

Jessica Irvine Economics Correspondent

THE Reserve Bank has made a dramatic bid to save the Australian economy from recession.

There can be little doubt after yesterday's stunning interest rate cut that the global financial crisis will change the shape of the Australian economy.

The statement from the Reserve Bank governor, Glenn Stevens, shows how quickly things have changed.

Statements from the bank usually involve subtle changes of wording and cryptic hints about the future of rates.

But Stevens threw the usual script out the window yesterday, instead announcing confidently that a "material change to the balance of risks" had occurred, which required a "significantly less restrictive stance of monetary policy".

In unusually colourful language he described how financial markets had taken "a significant turn for the worse" and how a "serious dislocation" had arisen in wholesale funding markets.

But the most worrying prediction contained in yesterday's statement is that commodity prices may have peaked.

To date all hopes for Australia's continued resilience from the global economic storm have rested upon continued strong demand for Australia's commodity exports. But Stevens made it clear that the global economic crisis is reaching even closer to Australian shores than most people realise.

"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."

If commodity prices fall, the Australian economy will have little to fall back on.

The boom in consumer spending and debt that fuelled economic growth in the early part of the decade is long gone.

The governor's statement also shows growth has overtaken inflation as the number one concern at the Reserve.

Annual inflation is still forecast to have hit 5 per cent over the past three months, but slower global growth is denting growth prospects at home.

"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."

Weighing it all up, the Reserve decided to "front load" planned interest rate cuts and deliver the biggest rate cut the economy has seen since it was coming out of the last recession.

"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," Stevens said.

But before home borrowers get too carried away, Stevens included a line to head off expectations of more big rate cuts.

"The board does not, however, regard that movement as establishing a pattern for future decisions."

The bank is hoping yesterday's cut may be enough to jolt the economy out of its growing torpor.

It is a bold and decisive move. But whether or not the Australian economy is headed for a recession may ultimately depend on factors outside the bank's control.

THE BANK ACTS

The Reserve Bank Statment

At its meeting today, the board decided to lower the cash rate by100 basis points to 6.0 per cent, effective 8 October 2008.

Conditions in international financial markets took a significant turn for the worse in September. Largescale 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. Economic activity in the major countries is also weakening, andevidence is accumulating of a significant moderation in growth in Australias trading partners in Asia.

The expansionary effects of the recent surge in Australias 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. Thus far, the overall path of economic activity in Australia appears to have been close to what the board had expected, with the needed moderation in demand occurring. The next CPI is likely to show an increase of around 5 percent over the four quarters to September, but the bank remains of the view that inflation will start to decline 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.

Given that background, the board judged that a material change to the balance of risks surrounding the outlook had occurred, requiring a significantly less restrictive stance of monetary policy. 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.

The board does not, however, regard that movement as establishing a pattern for future decisions. 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 23 per cent target over time.