Priced for economic ruin?

The RBA will cut interest rates to 2.75% around the middle of 2012 and leave them there until the start of 2013. So say financial markets which this morning have reacted to the turmoil in the US fiscal debate, ongoing ructions in the Eurozone, signs of a rapid cooling in Chinese growth and ongoing fragility in the local economy to price in a cash rate lower than the low point (3.0%) reached during the GFC.

While it seems that the market is a little over-cooked in that too many rate cuts are being priced in, there are some very stark contrasts between the situation now and those of late 2008 which support the case for sharply lower interest rates.

• In 2008, fiscal policy was eased by a huge (record) amount and there is no doubt this supported growth and meant the RBA didn't need to cut rates as much as was thought likely in early 2009. Now, we are part way through a record fiscal tightening meaning the RBA can set interest rates lower than if fiscal policy was stimulatory.
• In 2008, inflation was hovering around 4 to 5% which may have seen the RBA a touch reluctant to keep cutting and cutting - now, inflation is 2.5% and falling.
• In 2008, the unemployment rate was around 4% and labour price growth was above 4% - now the unemployment rate is a touch over 5% and labour price growth is on a slowing toward 3.5% - or less.
• In 2008, credit growth was 15%, now it is 3.5%.
• In 2008, the ASX was trading after reaching 6,750 points, now its trading around 4,000 points.

For these reasons among others, it is possible to build a case for the RBA moving to set interest rates towards the low point seen during the GFC. This is clearly what the collective wisdom of the market is saying right now as it increasingly looks to the economic fallout from the sovereign debt crisis, the sluggishness in the industrialised world and the cooling of activity in China as risks to Australia in 2012.

On balance, I am happy to stick to my forecast for the cash rate falling to 3.5% in June 2012 and for that to be the low point in the rate cutting cycle. But if I am wrong, it will probably be because the RBA has cut to a lower level as the above influences force its hand. The market just might be right.