RBA slashes rates by 25 basis points

The Reserve Bank has pushed the button on rates again this week and cut the official cash rate by 25 basis points. This brings rates down to 3 per cent which is a 49-year-low. In his statement on monetary policy, governor Glenn Stevens noted the deteriorating global conditions and weakening domestic outlook.

He said: "The Australian economy is contracting, though by less than those of its trading partners. Capacity utilisation has fallen from its peak, and will decline further over the rest of the year. With demand for labour weakening, growth in labour costs will probably also fall."

Opinion in the market was divided ahead of the RBA's meeting as many economists thought the bank would take more time to assess the impact of the 400 points cut since September and the effect of federal government's two stimulus packages.

The RBA's decision to continue its aggressive monetary policy easing shows just how worried the bank is about the state of the economy. Companies are continuing to shed jobs and keep investment plans on hold as they wait for clearer signs that the worst is over. The RBA has acknowledged that the economy will continue to contract throughout the remainder of the year.

Pundits are now predicting that the bank will make a few more small cuts over the coming months. At least another 50 basis points are expected to be cut by the end of 2009 as unemployment continues to rise. This means that the official cash rate is likely to settle somewhere around 2.25 per cent. Either way, we're getting very close to the bottom of the easing cycle. Governor Stevens highlighted in his statement that there was only ‘scope for a further modest adjustment to the cash rate'.

The Australian housing market is showing some signs of strength but the jobs data coming out this week will shed more light on how well the economy is actually holding up. The RBA is caught between trying to shield the economy from the worst of the global downturn and the risk of cutting rates too far.

It's certainly much more difficult to raise rates when jobs are still disappearing and the economy feels like it's in a recession. The reality is that rates will have to go back up at some stage. If the RBA is too liberal with monetary policy it may put the economy at risk of overheating and triggering the inflation genie. The market thinks that the RBA is likely to pause at its next meeting and then start to cut rates again in June.

The RBA will meet again on May 5 and the federal budget will be handed down on May 12.