ECONOMY - Why a rate cut is possible

Low consumer confidence and US and European economic turmoil prompted the RBA to avoid raising the cash rate, writes Shane Oliver

What is the impact on Australia of US economic turmoil and the European debt crisis?

The share market falls experienced since April have been due to poor global economic data and political dysfunction both in the United States and Europe. The main impacts locally have been on confidence and on the financial markets.

The effect on confidence is due simply to the fact that we are getting this bad news out of Europe nightly, which adversely affects business and consumer confidence which, in turn, has the effect of delaying spending decisions in the economy.

The effect on the financial markets is evident in falls on the share markets and the Aussie dollar.

Obviously, share market falls can lead to a loss of wealth, which is another negative for spending.

In terms of the Aussie dollar, some may see it as a good thing that the value of the dollar has dropped. The fall of the Aussie dollar has gone hand in hand with lower commodity prices.

If you’re in mining, these things probably aren’t so good because commodity prices have come off quite a lot. Alternatively, if you’re in manufacturing or tourism, you might say it’s a good thing.

But the main impact is on confidence, and confidence has been falling for a year or so.

I think the Melbourne Cup rate hike last year, following the earlier hikes, had a lot to do with that.

What’s happened is that an onslaught of rate hike stories has created negative sentiment, even up until three or four months ago, while in recent months this flow of bad news out of Europe has weighed on confidence more heavily.

I guess there is light at the end of the tunnel though, with increasing talk of a rate cut, which I previously had suggested would occur in October.

The cash rate has been on hold for almost a year now, but the tone of the Reserve Bank’s commentary, particularly in its monetary statements, has changed from ‘more rate hikes are likely’ to ‘the inflation outlook is becoming a bit more benign and that might provide scope to cut rates’.

So, they’ve gone from being hawkish to more dovish, which I think is clearing the way for a cut. We’ve got one pencilled in for November, but whether it’s in November or December, lower interest rates are on the way.

In hindsight, it would appear the cash rate went too high, but the Reserve Bank wasn’t to know that the world was going to fall apart again on the back of the European and US angst we’ve experienced in the past two months.

You’ve got to bear in mind that globally, only three central banks have cut rates: those of Brazil, Russia and India.

Australia is one of the world’s stronger economies, so it’s understandable that it takes them a while to move.

A couple of things have happened to cause the Reserve Bank to change its tone. The first thing is that Australian households have proved to be a lot more sensitive to higher interest rates than might have been thought.

At the same time, that has combined with bad news globally, causing the interest rate story to jump from hikes to cuts.

But it is going to take a succession of rate cuts over several months to boost confidence and entice investors back into the property market.

A 25 basis point cut on its own might not be enough. If there were a 25 point cut, followed by talks of more cuts later in the year, then I suspect by the time we get to the June 2012 quarter, the property market should be looking a little bit stronger.

By Shane Oliver, AMP chief economist