The Economy: RBA Cuts As Europe’s Woes Increase, Growth Data Out Today

A case of battening down the hatches and preparing the economy for worse to come?

The RBA yesterday cut the cash rate to 4.25% from 4.50%, its second successive rate cut, a move that also has the whiff of being linked to the series of moves last week by major central banks, and this Thursday night's widely expected rate cut from the European Central Bank.

The big four banks remained silent last night on whether a rate cut would be passed on, or passed on in full.

The cut saw the dollar drop as the currency lost some of its appeal.

It lost more than half a US cent to fall below $US1.02 before clawing back some of the loss to end around $US1.0230 this morning.

The local market extended its fall to be down 1.4%, or 65 points at the end.

Other markets in Asia weakened because of the warning from Standard & Poor's to the eurozone that all 17 countries would see their credit ratings cut (including the six AAA-rated countries) if Europe didn't arrive at a long lasting solution to the deepening crisis

In that light, there is a very strong suggestion in the statement yesterday from Governor Glenn Stevens that the bank is now more concerned with the external threat to domestic economic growth from Europe's woes, than from inflation, which has been the major focus for more than a year.

"The likelihood of a further material slowing in global growth has increased," Mr Stevens said in its statement accompanying the decision.

"Sovereign credit and banking problems in Europe "are likely to weigh on economic activity there over the period ahead.

"Trade in Asia is now seeing some effects of a significant slowing in economic activity in Europe," Stevens said. "Commodity prices have reflected this, declining further over recent months and taking pressure off consumer price index inflation rates," he said.

(We saw that with reports of a sharp cut in quarterly iron ore prices in some Asian markets yesterday.)

So the focus is on protecting the Australian economy in early 2012 against any fallout from Europe's crisis continuing or deepening, which could very well happen.

The RBA has shifted its stance to focus on bolstering (protecting?) domestic demand as the outlook from offshore; especially Europe turns gloomier amid the region's deepening sovereign debt crisis.

Those few words represent a significant change in policy approach from the central bank.

A month ago the final paragraph of the statement from Mr Stevens read "the Board concluded that a more neutral stance of monetary policy would now be consistent with achieving sustainable growth and 2-3 per cent inflation over time".

In other words, monetary policy had moved from being mildly restrictive up to October to neutral from November, and now it's been moved to a more reactive basis, as Mr Stevens said in his post meeting statement's final paragraph yesterday. The board, he wrote, would now set "policy as needed to foster sustainable growth and low inflation over time".

That means that if further rate cuts are needed to cushion the economy, then they will happen.

Yesterday's cut came a day before the release of third-quarter gross domestic figures which are likely to show Australia growing at about 1% (quarter on quarter or 4% annual) rate.

While that is faster than many other economies at the moment, the RBA seems to have decided that the threat from Europe has risen to a point where it must now move to protect domestic demand as Europe's crisis threatens global growth.

There's a whiff of rising concern about the problems in Europe, which were underlined yesterday by Standard & Poor's placing all 17 countries of the eurozone, including the six AAA-rated core countries, led by Germany, on creditwatch negative for a downgrade if Friday night's eurozone and EU leaders' meetings don't come up with a credible and long lasting resolution of the crisis.

This is what Mr Stevens said yesterday about Europe:

"The sovereign credit and banking problems in Europe, to which European governments are still seeking to craft a full response, are likely to weigh on economic activity there over the period ahead.

"Financial markets have experienced considerable turbulence, and financing conditions have become much more difficult, especially in Europe.

"This, together with precautionary behaviour by firms and households, means that the likelihood of a further material slowing in global growth has increased.

"Commodity prices have reflected this, declining further over recent months and taking pressure off CPI inflation rates. This has increased the scope for some easing in monetary policy in a number of countries."

That is significantly different from what he said in the November 1 statement about Europe:

"Financial markets have recovered somewhat from the turmoil of recent months, helped by stronger economic data in the United States and by signs that European governments are making progress in their efforts to deal with the sovereign debt and banking problems.

"Equity markets have gained ground and the Australian dollar has risen significantly as risk aversion has lessened. But it is likely to be some time yet before concerns about the European situation can definitively be laid to rest and the effects of the recent turmoil on confidence may result in a period of precautionary behaviour by firms and households."

In other words. Europe hasn't improved, the financial crisis is worse than it was, there's no sign of a realistic solution, so let's get a rate cut in before the meeting on Friday, or if by the end of the year when the European banking system will be under immense strain.

The Bank of Queensland and Members Equity were the only banks to pass on the rate cut yesterday.

Today's third quarter economic growth could be weaker than expected after some surprise falls in two key components, on top of the expected negative contribution from the fall in business inventories which we outlined yesterday.

The federal government slashed spending by far more than expected last quarter, a taste of the fiscal tightening yet to come over the next year.

Yesterday's data showed government spending fell a steep 2.5% in the third quarter to an inflation adjusted $78.9 billion.

That was much weaker than anyone expected and implied a drag on economic growth of around 0.6 percentage points of gross domestic product (GDP), the biggest subtraction since 1999, according to some analysts.

The balance of payments outcome will also cut GDP by 0.6%, and the 1.1% fall in inventories will knock growth lower as well.

But wages and salaries and company profits, plus investment and construction will still be powerful positive influences on overall growth.

The current account data showed that Australia's record-high terms of trade (an all time high in the September quarter, up 2.7%) also helped narrow its current account deficit in the third quarter to $5.64 billion, the lowest in over a year.

The surplus on goods and services also hit a record high of $6.8 billion in current dollars, lifting national income.

In today's data, look for the figures on domestic demand and final sales: they will tell us that despite the detractions from exports, inventories and government finance, the underlying economy is much, much stronger than it seems.