RBA Cuts Rates to Record Low, Cites Tapering As One Cause For Emerging Markets Pressures

The Reserve Bank of Australia (RBA) overnight cut its benchmark interest rate to 2.5 percent from 2.75 percent. The cut brings the rate to another record low as the RBA struggles to prop up the economy despite the drop in the resource sector due to a slowing China.

Pick-Up Next Year

"Recent information is consistent with global growth running a bit below average this year, with reasonable prospects of a pick-up next year," wrote Governor Glenn Stevens in the accompanying statement. "Commodity prices have declined but, overall, remain at high levels by historical standards. Inflation has moderated over recent months in a number of countries."

Also, Stevens noted that recent policy comments from the Federal Reserve have had a noticeable effect on global financial markets, a shot at his counterpart Ben Bernanke on the FOMC. "Globally, financial conditions remain very accommodative, though the recent reassessment by markets of the outlook for US monetary policy has seen a noticeable rise in sovereign bond yields, from exceptionally low levels. Volatility in financial markets has increased and has affected a number of emerging market economies in particular."

Economy Below Trend

Stevens noted that the Australian economy has performed below the medium-term trend forecast by the bank in a sign that more stimulus could come in the future. "[The weakness in the economy] is expected to continue in the near term as the economy adjusts to lower levels of mining investment."

"The unemployment rate has edged higher. Recent data confirm that inflation has been consistent with the medium-term target. With growth in labour costs moderating, this is expected to remain the case over the next one to two years, even with the effects of the recent depreciation of the exchange rate."

Aussie Downside

Governor Stevens also commented that, despite the nearly 15 percent depreciation of the Australian dollar since late April, there could be more downside for the currency. "It is possible that the exchange rate will depreciate further over time, which would help to foster a rebalancing of growth in the economy."

"The Board has previously noted that the inflation outlook could provide some scope to ease policy further, should that be required to support demand. At today's meeting, and taking account of recent information on prices and activity, the Board judged that a further decline in the cash rate was appropriate. The Board will continue to assess the outlook and adjust policy as needed to foster sustainable growth in demand and inflation outcomes consistent with the inflation target over time."

The "scope" that Stevens mentioned was the key for markets to predict this rate cut; the OIS swaps markets had forecast actually a greater than 100 percent chance of a 25 basis point cut, meaning some traders were looking for a 50 basis point cut, before the meeting. Should this language revert back to "low inflation provides scope for further easing," it would most likely signal further rate cuts to even lower record lows for the cash rate.

Markets React, Aussie Rallies

Australian stocks traded slightly lower on the news overnight, as the S&P/ASX 200 Index fell 0.11 percent to 5,105.63, although the index has still gained nearly 13 percent year to date. Shares did close off of early session lows however.

The Australian dollar rose following the cut on what appeared to be a buy-the-rumor-sell-the-news trade. Also, the rise in the currency could have been predicated on the fact that some were expecting a 50 basis point rate cut.