The visible hand in economics

Reserve Bank to slash rates to 5.5%?

Posted on: November 19, 2008

I get back into the country and everyone is telling me that rates are going down by 100 basis points in the next meeting – however no-one will tell me why!

One big reason appears to be the large rate cuts by the Bank of England (down 150 basis points) and the Reserve Bank of Australia (down 75 basis points – with statement) – however, I don’t see how this moved market expectations from a 50 basis point cut to a 100 basis point cut?

The retail banks are saying that the economic situation has worsened over the past month – but has it? Some measures of the tightness of credit conditions have improved since late October (eg the TED spread), while inflation outcomes have increased and the labour market has shown itself to be slightly more resilient than expected. Of course things are bad – but they haven’t deteriorated.

Another factor is “inflation” – petrol prices have fallen drastically, implying that annual growth in the CPI will also fall. However, this isn’t a decline in inflation, which is the trend rate of growth in the price level. Cutting on the basis that the headline figure for inflation will collapse is a risky strategy – as it ignores the fact that once the decline in petrol prices falls out of the data future increases in the CPI will be greater, as it implies that domestic demand will be higher than it would have been otherwise. In fact, recently the Bank appears to be implying that the more petrol prices falls, the greater actual inflationary pressures are (here).

Did I miss something important when I was away for the last two weeks, or is the market over-reacting here?

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