AAP Economics: Lower fed funds to clear way for RBA to cut more

AAP General News (Australia)
04-05-2001
AAP Economics: Lower fed funds to clear way for RBA to cut more

By Garry Shilson-Josling

AAP Financial Markets Economist

Tel: 61 2 9322 8737 Fax: 61 2 9322 8600

Yesterday's interest rate cut by the Reserve Bank of Australia brought the overnight
cash rate down to 5.00 per cent, level with the US fed funds rate.

After a succession of recent lows hit by the Australian dollar and consequent signs
of concern from the Reserve about imported inflation, it is unlikely that Australia's
central bank would be keen to bring the cash rate below fed funds, for fear of undercutting
support for the exchange rate.

This is not to say the fed funds rate is an absolute floor for the Reserve's key indicator
for monetary policy. For much of 1997, 1998, 1999 and 2000 the overnight cash rate was
a quarter or half per cent below fed funds.

But a potentially negative differential at the moment would undoubtedly make the Reserve
think twice before easing monetary policy again.

Accordingly the outlook for fed funds is crucial to the outlook for overnight cash.

This is reflected in forward rates which show the cash rate is expected to exceed fed
funds over the coming six months by a consistently small margin.

The following table shows Wednesday's closing fed funds futures -- implied monthly
averages, and implied forward rates from the Australian bank bill market today:

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Month Fwd 30 day rates US fed funds futures Diff.

April 5.00 4.90 +10

May 4.88 4.66 +22

June 4.59 4.44 +15

July 4.56 4.29 +27

August 4.37 4.26 +11

September 4.33 4.21 +12

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Fed funds futures prices are consistent with a quarter per cent cut at the May 15 Federal
Open Market Committee meeting, and another at the June 26 meeting. In both cases the market
has factored in some additional downside risk, and a further move to 4.25 per cent between
the June meeting and the next, which will be held on August 21.

The state of the US economy suggests the market is not getting too far ahead of itself.

Most key indicators, from business surveys like the monthly Purchasing Managers' index
to factory goods orders and industrial production say the economy is struggling to maintain
positive growth. Gross domestic product expanded by just 0.3 per cent in the fourth quarter
of 2000, and employment growth has slowed in response.

The main source of the economic slowdown has been the depressing impact of falling
share prices on consumer spending, business investment and inventories.

From its peak a year ago until March 20, when the Fed last cut the fed funds rate (from
5.50 to 5.00 per cent), the US share market had lost $US4.25 trillion of its value.

Since then, figures have been released showing durable goods orders falling further
(in February), aggregate corporate profitability declining in the fourth quarter and a
rash of corporate announcements of downgraded earnings expectations and large-scale layoffs.

Between the last rate cut and now the share market has fallen by roughly another $US440
billion and the pace of the decline has, if anything, accelerated.

The next release of hard economic data from the US will be the monthly employment report
from the Bureau of Labor Statistics, due on Friday.

According to a survey by analytical firm briefing.com the market is expecting a weak
rise of 70,000 in non-farm payrolls, just under half the average for the preceding twelve
months, and a lift in the unemployment rate to 4.3 per cent from, 4.2 per cent.

Amid an ongoing barrage of bad news from the share market, employment results along
those lines would harden the market's confidence in the currently anticipated downward
path for fed funds.

As a result they would also bolster expectations that the RBA's cash rate target will
be able to follow it down without concerns about the Aussie/US interest rate gap upsetting
the exchange rate.

AAP

KEYWORD: ECONOMY RATES OUTLOOK

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