Glenn Baker, CFO
ING DIRECT

The Reserve Bank lowered the official cash rate by 0.25% to 4.5% per annum on Tuesday following the November Board meeting. This was the first change to monetary policy since it last raised rates in November last year.

Thepotential for this move was signalled last month when the Reserve Bank observed that ‘an improved inflation outlook, if confirmed by further data, would increase the scope for monetary policy to provide some support to demand, should that prove necessary’.

The key influence was the release of the September quarter inflation data in the last week of October. This showed that inflation was indeed moderating with the underlying measures falling to the lower end of the target range of 2% to 3%. Further, the Reserve Bank is now forecasting that inflation will stay in its target band for some time to come.

Inflation was, however, only one element behind today’s decision, albeit a highly important one.

As has been observed over recent months the ongoing unstable market conditions and the entrenched concerns about European sovereign debt levels and the flow on impact of revaluation losses on European banks has seen economic activity in Europe and the outlook for recovery weaken considerably.

This has led to a downgrading of global growth expectations. With theAsian growth engine,China, also moderating growth, this global slowdown hasin turnseen the outlook for Australia brought into question.

At the heart of concern is a weakening in both consumer and business confidence. This results in a lack of preparedness to spend or invest. To lift economic activity, confidence firstly needs to be restored. The easing in the official cash rate will flow through to borrowing costs both for business and consumers, particularly home loan borrowers. This will have a positive effect on cash flow making more money available for spending.

Over and abovethe simple effect of increasing available spending power is the signal sent (and received), that the Reserve Bank is prepared to stimulate the economy if needed. This is a shift in emphasis from the position communicated earlier in the year, only a matter of a few months ago, that the next move in interest rates would be up to continue to stave off rising inflation. As a result this move will produce a healthy boost to confidence. So it is not so much about the size of the move as it is the direction – the shift in thinking at the Reserve Bank.

Going forward it is not possible to be definitive about the next move in monetary policy. On balance, the bias, if there is one, has probably shifted toward further easing. This would be the case at least until the European situation is resolved or at least the debt markets stabilise on the basis that a credible plan is in place to satisfactorily resolve the debt crisis.

Nonetheless, if the economy starts to grow at a faster rate and inflation begins to re-emerge, the Reserve Bank could reintroduce a tightening bias, going back to the positioning it held prior to the recent global turmoil.

It should not be overlooked that the Australian economy is still experiencing record terms of trade and a huge boost to national revenue from mining exports. This will continue and very large investments are going into building on the strength of this sector.

The weaker sectors such as retail spending and housing could well respond to the monetary stimulus, thus adding to the growth coming from the mining boom. In this scenario total economic growth would move back above trend levels.

An important determinant for the future is also employment. Whilst this has weakened a little in recent months with the unemployment rate rising above 5% it is likely that strengthening growth would see unemployment fall again and wage pressures which are currently subdued possibly re-emerging. This could be the foundation for a different perspective on inflation than that currently held.

The Reserve Bank has responded to the needs of the economy and reduced the official interest rate to build confidence and stimulate growth at a time when inflation is looking subdued. The next move in policy could be in either direction, up or down.

Any worsening of the European debt crisis could lead to further policy easing. Stabilisation of the European situation leading to animproved global growth outlookwould feed into positiveoutcomes for Australia. In that scenario interest rates might need to be raised. The balance of probabilities seem to be pointed toward further relaxation of interest rates in the short term.