Reserve Bank of Australia cuts rate to 7%; first cut since 2001

The Reserve Bank of Australia has cut its official cash rate by 25 basis points to 7%, which is its first cut since December 2001. This was widely expected by financial markets. (Updated to include comments from JP Morgan The commentary detailed below did not suggest what the Reserve Bank might do next. It was careful to avoid comments about whether its policy stance was neutral or whether more would need to be done to revive a slowing economy. The Australian dollar rose shortly after the statement, suggesting markets believed the lack of a clear signal about further rate cuts meant the chances of further rate cuts had reduced. In recent days commentators have mused that rate cuts may not be aggressive given some revival of business confidence and activity in recent weeks. Here is the full statement from the RBA.

At its meeting today the Board decided to lower the cash rate by 25 basis points to 7.0 per cent, effective 3 September. Inflation in Australia has been high over the past year in an environment of limited spare capacity and earlier strong growth in demand. In these circumstances, the Board has been seeking to restrain demand in order to reduce inflation over time. As a result of increases in the cash rate last year and early this year, additional rises in market interest rates and tougher credit standards, financial conditions have been quite tight. Some further tightening has occurred over the past couple of months. Conditions in international financial markets remain difficult, with heightened concerns over credit persisting. The evidence is that the tight financial conditions, in conjunction with other factors including higher fuel costs and lower asset values, have exerted the needed restraint on demand. Indicators of household spending have recorded subdued outcomes over recent months, and credit expansion to both households and businesses has slowed. Surveys suggest a softening in business activity and growth in production has slowed. Indicators of capacity utilisation, while still high, are declining and there have also been some signs of an easing in labour market conditions. The rise in Australia's terms of trade that has occurred is working in the opposite direction, adding substantially to national income and ability to spend. Fixed investment spending by businesses continues to be very strong. At the same time, high prices of oil and a range of other commodities have added to global inflationary risks. They are also dampening growth in a number of countries. Given the opposing forces at work, considerable uncertainty has surrounded the outlook for demand and inflation. On balance, however, it is looking more likely that household demand will remain subdued and overall economic growth slow over the period ahead. Inflation is likely to remain relatively high in the short term, with the CPI affected by the high global oil prices in mid year and other increases in raw materials prices. But looking further ahead, the outlook for demand suggests that inflation in both CPI and underlying terms is likely to decline over time, provided wages growth remains contained. The Bank's forecast remains that inflation will fall below 3 per cent during 2010. Weighing up the available domestic and international information, the Board judged that there was now scope for monetary policy to become less restrictive. 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.

Today's commentary leaves open the door for another cut in the official rate in coming months, but further eases are far from a "done deal". It would be unusual for the RBA to adjust policy once and then stop, and we continue to look for a second 25bp rate cut before the end of the year. We had, however, expected back-to-back rate cuts in September and October, but it now is clear that RBA officials are in no rush. As such, the second rate cut probably will not come until December. Indeed, a complication for the RBA is that the 22 October CPI report almost certainly will show another acceleration in inflation; our forecast is that headline inflation will be north of 5% in 2Q. Having to explain a rate cut in November immediately after the release of a high CPI print will be awkward, but not impossible. This complication, though, makes a rate cut in December more likely than November. We still look for total easing of 100bp - including the 25bp delivered today - by June 2009. This means the RBA will end what is likely to be a measured, modest easing cycle with monetary policy still leaning slightly to the tight side of neutral (we estimate that the neutral cash rate is 5.75% to 6%). RBA officials, therefore, are lifting their collective foot off the brake slowing the economy, not depressing the policy accelerator. Indeed, RBA officials, having engineered the slowdown in domestic demand via tighter policy, will be cautious not to reignite consumer spending, in particular, with too much easing too quickly, particularly given that the government only recently paid another round of generous personal income tax relief. The RBA's caution is understandable because we are headed into uncharted waters - never before has the RBA embarked on an easing cycle with inflation so far above target, and accelerating. Clearly, RBA officials believe that the weakness in domestic demand is significant and likely to be sustained, so much so that their anxiety about growth outweighs their concerns about elevated inflation and the risk that this inflation pressure could feed into claims for higher wage claims, a risk mentioned again in today's statement.