Reserve Bank of Australia shocks economists

by Mark Benson on May 1, 2012

in Money, Business and Finance

Spare some change governor?

The Reserve Bank of Australia has today shocked the vast majority of economists after announcing a 0.50% reduction in base rates. The headline rate is now 3.75% which is the lowest it has been since 2010. The vast majority of economists had already pencilled in a 0.25% reduction in base rates and the additional reduction took many by surprise. However, there is a growing feeling that the Australian economy is nearing something of a crossroads with concerns about economic growth with the exception of the mining sector.

Why did the Reserve Bank of Australia act so decisively?

There is no doubt that investment markets were taken aback by the size of the rate reduction but there are a number of factors which are now coming into play. There is concern about the short to medium-term outlook for the Australian economy while on the other side inflation appears to be under control.

Subdued economic growth

No matter how well the Australian economy performs it is still at the beck and call of not only the worldwide economy but also major trading partners such as China and India. Worldwide economic growth is starting to turn down again with the Eurozone crisis far from over and growth in China, by far and away Australia’s largest trading partner, having fallen to a three-year low.

Against this background maybe the reduction in base rates today will help to head off any potential slowdown in the short to medium term and make liquidity more available for businesses and consumers.

Inflationary pressure subdued

The rate of inflation in Australia ran out of control for a short term last year due to the strength of the mining industry and various natural disasters. However, the rate is now in a more comfortable zone and expected to remain in the government’s 2% to 3% range for the foreseeable future. Against this background the Reserve Bank of Australia feels it is more than appropriate to reduce base rates without the potential risk of feeding the monster which is inflation.

Could we see more rate reductions in the short term?

Analysts are now scratching their heads as to what the immediate outlook is for the Australian economy and indeed whether there is scope for further reductions in base rates. The consensus seems to be that Australian base rates will be at or around 3.25% at the end of 2012 which would mark a significant reduction over the period. This is by no means set in stone and any planned reductions could in many ways be blocked if inflation was to find renewed strength in the short to medium term.

The truth is that the Australian economy cannot continue to power ahead under its current structure and its excessive reliability upon trading partners such as China. There needs to be change, there needs to be more fluency in the money markets and the authorities and the Reserve Bank of Australia need to work together for the good of the economy.

How will austerity measures hit economic growth?

It is widely expected that the government will announce US$36 billion in spending cuts, tax increases and additional revenue streams in the forthcoming budget. The goal is, and has been for some time, to introduce a budget surplus even during these times of economic hardship. However, there is now growing concern that a 0.50% reduction in base rates would seem to suggest a more challenging period ahead for the Australian economy therefore would it be sensible to take an extra US$36 billion from the economy?

There is no doubt that political pressure has in some shape or form had an impact upon the decision of the Reserve Bank of Australia to reduce base rates. There is now a need for the government to play its part and reduce the expected US$36 billion austerity measure program which has been pencilled in for the next budget. If the Reserve Bank of Australia “plays its part” with regards to economic growth then there is no reason why the authorities would need to reduce spending at a vital point for the economy.

Are we approaching a short-term feel good factor?

There are high hopes that the 0.50% reduction in Australian base rates will in many ways kick start further economic growth although this is by no means guaranteed. There is the potential for a short-term feel good factor to return to the Australian economy just in time for next year’s election with the ruling Labor Party well behind in the polls. So are we approaching a situation where politics is placed head and shoulders above the medium to long-term outlook for the economy?

There is no doubt that politicians will look to play their part in the months ahead prior to next year’s general election. They will attempt to inject hope into the Australian population and paint a very rosy economic picture for the longer term. Whether or not this will turn out to be the case remains to be seen because politics is a ruthless game and in many ways influenced by short-term factors.

Interesting times ahead for the Australian economy

While the reduction in base rates will no doubt grab the attention of media moguls around Australia and indeed around the world there are other pressing issues to consider. The economy is currently split between mining and non-mining activities and these areas of the economy are moving at very different speeds – indeed many would argue they are moving in different directions!

The current government and the next government will need to address the structural issues which have arisen due to significant economic growth over the last few years. This is very much part of moving from a developing/developed economy to a more mature and more settled environment. There will still be a relative reliance upon the mining industry although in many ways the politicians will need to bring in new sectors for the medium to longer term.

The recent past has been very rosy for the Australian economy and while there’s no reason to doubt that the future will not be as rosy, there is a need for change in the structure of the business arena.

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