RBA to cut rates as inflation falls sharply

A rapid slowdown in inflation means that the Reserve Bank can safely keep cutting interest rates when it meets on Tuesday next week. The Australian Bureau of Statistics released the consumer price index data for the December quarter this week and it was the first time that inflation had fallen in two years. This drop was the largest quarterly fall in more than a decade and lower fuel prices were primarily responsible for the weaker numbers.

The headline inflation rate fell by 0.3 per cent after an increase of 1.2 per cent in the September quarter. This means that the annual rate of inflation is now 3.7 per cent, down from 5 per cent. The Australian economy is definitely slowing in response to the worsening global economic conditions and falling commodity exports.

Other economic indicators are confirming that the Australian economy is contracting, and many market participants believe that Australia has probably already moved into recession. The outlook is set to worsen with the International Monetary Fund predicting that the global economy will only grow by 0.5 per cent this year. This means that the RBA’s job now is to use monetary policy as a tool to prevent our economy from slipping into a protracted downturn.

The RBA’s focus has firmly shifted away from fighting the inflation battle of 2007/2008, when the official cash rate was as high as 7.25 per cent in March 2008. Rates have since been slashed by 400 basis points, bringing the official cash rate down to 3.25 per cent. Lower interest rates encourage households and businesses to borrow and spend more which are critical factors in keeping the economy growing.

Other central banks are all moving in the same direction, with the New Zealand central bank cutting rates this week by 150 basis points to a record low of 3.5 per cent.

The difficulty that Glenn Stevens and his board face is getting the policy levers just right. If rates are cut too aggressively, then the inflation genie could potentially become an issue again as the economy recovers too quickly.

Most market commentators are predicting that the RBA board will cut the official cash rate by at least 50 to 100 basis points on Tuesday. Although the full effect of the previous rate cuts has yet to be felt, more rate cuts are still forecast for later in 2009.

Infochoice.com.au