Big interest cut is on the way – but will the banks pass it on?

A growing number of economists are urging the RBA cut official interest rates by 0.5% when it meets next Tuesday. But it appears increasingly unlikely the banks will pass the bulk of the rate cut on, as the global financial crisis has pushed up the cost of the banks’ short term funding.

While many economists are unsure whether the RBA will cut by 0.25% or 0.5% on October 7, ANZ economist Katie Dean is one of those predicting the central bank will opt for the big move.

“Tightening local financial conditions related to the credit crisis and expectations of weaker global economic growth suggest an aggressive move is warranted,” Dean argues. “If the RBA does not validate market expectations for rate cuts, financial conditions would likely tighten further.”

Dean says the RBA’s inflation-fighting stance must be set aside in the face of the current crisis.

“Locally, there are now growing downside risks to the outlook for commodity prices, consumer spending and business investment. This change in the balance of risks means fighting inflation should now be second-order to supporting growth.”

But while the RBA is certain to cut rates, the banks will not be keen to pass on the cut to borrowers. The turmoil on financial markets has caused banks to stop lending to each other and start hoarding cash. As a result, short-term funding costs continue to soar.

The gap between the London interbank offered rate and the overnight indexed swap rate – a key measure of the scarcity of cash – hit a new record last night of 246 basis points. By way of comparison, the spread averaged just 6 points between the start of 2006 and mid-2007.

JP Morgan bank analyst Brian Johnson told the Australian Financial Review he was surprised to see the banks pass on last month’s 0.25% cut and says it is highly unlikely they will be able to pass on a full 0.5% cut.

Yesterday’s credit figures revealed the extent of the slowdown in lending. Business lending grew by relatively solid 0.6% in August, taking the annual growth rate to 13.6%. That’s a long way from the growth rate of 24% in November last year, when the economy was running on all cylinders.

Today we want to know your thoughts on Australia’s interest rate position. How big should the RBA cut be? Will the banks even pass it on? And is the credit crisis restricting your ability to grow? Take our quick SmartCompany Poll and let us know what you think.