Financial Crisis Prompts Large Interest Rate Cut

At its meeting today, Australia’s Reserve Bank decided to cut its key interest rate sharply from 7 percent to 6 percent, effective as of tomorrow. The last time the bank took such bold action was in 1992.

Justifying the cut, the bank said that conditions in financial markets world-wide took a significant turn for the worse in September and financial failures in several major countries have been accompanied by heightened instability in the markets.

The ongoing credit crunch means financing is likely to be difficult around the world for some time to come. This is also affecting Australia, albeit less than in many other countries, given the relative strength of Australia’s banking system.

Economic activity in major economies is also weakening, and it looks as if growth may be slowing in Australia’s Asian trading partners. Also, many of Australia’s commodity export prices have declined from their peaks. This, combined with below-trend growth in the global economy, suggests that global inflation will ease in 2009.

Australia’s next inflation figure, at around 5 per cent, is likely to be well above the Bank’s target but the Bank remains of the view that inflation will start to decline in 2009.

The recent deterioration in prospects for global growth, together with much more difficult market conditions even for creditworthy borrowers, now present the risk that demand and output could be significantly weaker than earlier expected. Should that occur, inflation would most likely fall faster than earlier forecast.

It does not look likely that Australia’s retail banks will pass on the full one percent cut to their customers. Westpac was the first bank to respond, lowering its variable home loan rate by 0.8 percent rather than the full one percent. Commonwealth Bank, National Australia Bank, ANZ and St George then followed suit.