October 2, 2012 6:54 am

Australia cuts interest rates by 25bp

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Australia’s central bank cut rates on Tuesday amid fears that the resources boom that has driven the economy was running out of steam more rapidly than expected, while consumers and other industries were failing to step into the breach.

The Reserve Bank of Australia reduced interest rates by one-quarter of 1 per cent, citing the slowdown in China and Europe’s recession in its decision to reduce rates to 3.25 per cent.

The RBA also warned the predicted peak early next year in investment by the Australian resources sector, which has been the driving force of the economy, may be lower than had been previously expected.

The move, which took many economists by surprise, followed rate cuts and other stimulative measures introduced around the world as policy makers try to stoke flagging economies.

The US Federal Reserve and European Central Bank have both acted to shore up confidence in markets in the past month, while the People’s Bank of China has been pumping record amounts of short-term cash into money markets to ease liquidity strains there.

The Australian dollar immediately dropped by more than half a cent to US$1.031, while the main Australian stock market index rose 1 per cent to 4433.7 points.

Australia’s two-speed economy has been dominated by the China-led resources boom in recent years, but the country now needs to see a pick-up in domestic demand and consumption to protect its 3.5 per cent-plus growth rate.

“As this [resources investment] peak approaches it will be important that the forecast strengthening in some other components of demand starts to occur,” the RBA said. It noted that home buying was subdued, consumption growth firm but temporary and credit growth had softened.

The slowdown in China, Australia’s main trading partner, has hit commodity prices hard. Iron ore, Australia’s most valuable export, has fallen by more than one-third since July, while thermal coal, another important export, is close to two-year price lows.

The RBA said that Australia’s terms of trade – a measure of the balance between the costs of imports and exports – had declined by 10 per cent since last year’s peak and would continue to fall. This will mean the country is spending more on imports relative to exports, which could hurt domestic demand and investment.

Analysts at Deutsche Bank saw the move being designed to strengthen the “other components of demand”. “We suspect today’s 25 basis points cut will not be enough in the face of a significant negative terms of trade shock and an exchange rate that in our view is likely to remain elevated,” the analysts wrote.

Indeed, the RBA itself said the Australian dollar had “remained higher than might have been expected, given the decline in export prices and weaker global outlook”.

Economists had not expected a cut so soon, although the market had priced in an 80 per cent chance of a quarter-point cut this month and is pricing in further cuts to 2.5 per cent over the next 12 months – lower even than during the aftermath of the 2008 financial crisis.

However, Paul Bloxham, chief economist at HSBC in Australia and New Zealand, reckoned the RBA would stop cutting rates before then. “Looking forward, as we see the Chinese growth cycle as close to bottoming, we also have in mind that the RBA may be nearing the end of its easing cycle,” he said. “We see the 85bp of cuts priced in over the next year as too much.”

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