RBA says it’s time to muscle up

Reserve Bank Board meeting

– The Reserve Bank Board cut the official cash rate by 50 basis points (half of a percentage point) to 3.75 per cent. The cash rate is at the lowest level in over two years (March 2010). The next RBA Board meeting is on June 5 2012.

– The Reserve Bank has justified the large rate cut in terms of inflation. “Over the coming one to two years, and abstracting from the effects of the carbon price, inflation will probably be lower than earlier expected, but still in the 2 – 3 per cent range.”

What does it all mean?
– In short, a tremendous decision. Forget the old stereotype of the Reserve Bank being a super-conservative body. This is a courageous decision by the Reserve Bank. Not only will the super-sized rate cut provide real stimulus, but it will also boost much-needed confidence.
– The Australian economy has been a lot like a long distance runner. The long expansion has made the economy lean and mean, but it has lost muscle over time. Now is the time to muscle up – with the Reserve Bank implying that the economy can afford to beef up and confront the challenges that lie ahead.
– Last month the Reserve Bank clearly laid the groundwork for a rate cut. The message was that rates would be cut, provided that inflation remained low. Inflation did its job. And today the Reserve Bank was as good as its word, cutting interest rates by a half a per cent.
– We believe the Reserve Bank will now sit back a few months and assess whether the super-sized rate cut actually works. CommSec is pencilling in another rate cut (quarter of a per cent) in August, should it be necessary.
– The last rate cut of more than a quarter of a per cent was in February 2009 at the height of the global financial crisis when the RBA cut rates by a full percentage point. Apart from that period the Reserve Bank last cut by half a per cent back in April 2001 in response to a weak global economy and a contracting domestic economy.
– Even if the banks pass on half of the rate cut, monetary policy would now be considered stimulatory (below long term averages), albeit slightly stimulatory. In terms of the other financial indicators, home prices are flat; borrowing is weak; the Australian dollar is still historically high;
– Will the rate cut boost the economy? It should, even if banks can’t fully pass on the rate cut. The size of the move will clearly boost confidence. But if people don’t follow through and spend, it has no impact.

Again, if the rate cut doesn’t cause people to buy or build more homes or spend, employ or invest then the rate cut is a ‘damp squib’ – it is akin to pushing on a piece of string. People don’t just need interest rates to come down, they also need confidence to act on the easier financial conditions. This rate cut provides confidence.

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