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June 6, 2012

THE key comments in the Reserve Bank’s announcement of a quarter-percentage-point cut in the cash rate to 3.5 per cent yesterday were that market sentiment had deteriorated since the cash rate was lowered by a half a percentage point on May 1, and that households and businesses continued ”to exhibit a degree of precautionary behaviour, which may continue in the near term”.

They are descriptions of the consequences of fear, basically. The central bank also said that Europe’s economy had weakened and that growth in China had slowed, but those developments and more recent signs that America’s economic recovery is slowing are symptoms of the erosion of confidence that has accompanied the escalation of Europe’s sovereign debt crisis.

We are dealing with a less extreme but nevertheless worrying version of the economic arrhythmia that flowed from the collapse of Lehman Brothers and the near-collapse of the global financial system in September and October 2008.

Business activity ground to a halt after the Lehman collapse, plunging the world into an economic downturn that fed back into the financial markets, producing a second market slide.

This time it is producing the Reserve’s ”precautionary behaviour”. Deals are being postponed, and business investment proposals are being reconsidered. Market activity is almost exclusively focused on capital preservation instead of capital growth, and household spending is being cut back to essentials.

As the Reserve notes, the flight from risk has intensified in the past month. Anecdotal reports of a sudden downturn in activity and demand are circulating, and there are two possible conclusions.

The first is that inaction is rational behaviour. In times such as this, fortune does not necessarily favour the brave, and in most cases won’t.

The second is that there is no reason to be confident that this ”risk-off” behaviour will end soon. Europe is the key, and in Europe there are no quick fixes, and some looming hurdles in Greece’s election of June 17 and the tightening squeeze on the Spanish government as it deals with a recession-induced revenue downturn and the prospect of rescuing its banking system from property losses that could run to €100 billion ($A128 billion).

It looks as if Spain is going to need a lifeline, an injection of capital directly into its banks if not a Greek-style government bailout, and finance ministers from the G7 nations were in a conference call last night to consider their options.

The erosion of confidence and its potential to feed back and undermine economic growth is the main target of the latest cash rate cut, and while the Reserve did not say outright yesterday that it had more room to cut the cash rate, it does: in that respect Australia is almost uniquely placed. Official short-term interest rates in the United States and Japan are already at zero per cent, effectively. They are sitting at 1 per cent in Europe, and as bad as Europe’s situation is, the European Central Bank is not expected to cut its key rate when it meets later today because it wants to preserve what little firepower it has left.

Northern-hemisphere governments, meanwhile, are so loaded with debt that the debate about whether austerity programs should be replaced by growth programs is surreal – they have very little borrowing power left.

Here there is plenty of latent borrowing power, despite the opposition’s bleatings about the size of the debt load. Treasurer Wayne Swan is sticking to the May budget’s target of a surplus in 2012-13, but he could push the target out by a year and deliver additional fiscal stimulus without endangering Australia’s triple-A credit rating.

Today’s national accounts should confirm that while Australia is still a two-speed economy, with strong growth in Western Australia and Queensland and much weaker growth in Victoria and New South Wales, its overall rate of expansion is 3 per cent-plus a year, not far from the long-term trend.

Growth needs a boost in the east, and yesterday’s rate cut helps, but as the Reserve noted in its statement yesterday, bank lending rates are already slightly below the long-term average.

They will fall again now, although the big banks are unlikely to pass on the full quarter of a percentage point cut. Their borrowing costs are rising again as fear about Europe intensifies, and the battle they are waging for customer deposits that they must build in order to meet tough post-crisis funding ratios is also keeping the price of deposit funding relatively high. The Reserve had cut its cash rate by 1 percentage point in three steps ahead of yesterday’s meeting, and deposit rates had only fallen by about half as much.

Australia is nevertheless still growing, still on an income drip-feed from a commodity demand boom that has slowed but not died, and almost uniquely placed among the developed industrial nations to respond to any further weakening in either the domestic or global economy.

Of the OECD group of nations, only Canada is in a comparable position. We are still a lucky country.

Read more: http://www.theage.com.au/business/climate-of-fear-forces-rbas-hand-20120605-1zu9p.html#ixzz1x0moJYHg

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