Sourced Lending Central  20/03/2009

The prospect of rising unemployment should ensure interest rates will be lower three weeks from now. The Reserve Bank of Australia (RBA) takes a risk-management approach to setting interest rates. It balances the expected pay-off from moving, or not moving, interest rates against the adverse consequences if the policy adjustment turns out to be the wrong one. As it heads into the April 7 meeting of its board, the RBA is faced with a clear choice. It could leave interest rates steady, as it did earlier this month, in the expectation that its earlier rate cuts - along with the government’s fiscal boost, lower oil prices and the lower exchange rate - has done enough to see the economy through the tough times.

Or it could cut the cash  rate, which is already at a 45-year low of 3.25 per cent, to make doubly sure there is enough stimulus in the pipeline to prevent the recession from setting in. In those terms it was not an easy decision two weeks ago in Sydney and will be no easier when the board’s travelling show reaches Brisbane in just under three weeks.

The key problem is that the effect of that combination of positive forces acting on the economy is unclear, so it is unclear whether more of a boost from lower interest rates is needed. But the decision will not be made solely on the basis of whether another cut is judged necessary. The big question is what if the RBA’s assessment of the economy turns out to be wrong.

Maybe a rate cut that seemed necessary at the time will turn out to have been one too many. Or maybe hindsight will show a wait-and-see approach was overly cautious. Only time till tell, and not until well after April 7. So the RBA has to go by its best educated guess - and the knowledge that there is a good chance that guess might be significantly wrong. It has to weigh up the possible consequences if the forecasts underpinning them are off-target. And in this case the risks do not appear to be symmetrical. If it turns out a rate cut or two was needed, but was put off, the consequence will be a longer, deeper recession.

Thousands, perhaps tens of thousands more people would be stacked onto the scrapheap of unemployment, businesses will be ruined, careers will be derailed and investment in productive capacity will be shelved. But if a cut is made and turns out to have been unnecessary - adding more fuel to the economy than needed - the potentially negative fallout will be on inflationary pressures. The economy will grow faster than expected, reaching its full capacity earlier.

In the past the main pressure point for inflation in Australia has been the labour market, but the labour market now is weak. The number of out-of-work jobseekers has risen by 158,000 in the past year, with half of that rise in just the past two months. The unemployment rate in February was 5.2 per cent, up from 3.9 per cent a year before. And all the indicators, from a contracting economy to surveys of job ads and the employment plans of businesses, say we have not seen the worst of it by any means. It will be a long time before the labour market finally responds to any over-stimulation of the economy and it will be even longer before it has regained enough momentum to pose an inflationary threat. There will be plenty of time to adjust policy settings to slow the approach to full employment and head off an outbreak of wage inflation.

In short, the risks attached to cutting rates unnecessarily seem small enough to warrant seeing a rate cut as insurance against the risk of weaker economic growth rather than a gamble that tempts an inflationary fate