KEY POINTS:
Turmoil in international financial markets loomed large in the Reserve Bank's surprise decision to cut the official cash rate 50 basis points to 7.5 per cent yesterday - the steepest cut since2001.
Governor Alan Bollard has recently returned from the US Federal Reserve's annual conference for central bankers in Jackson Hole, Wyoming.
"The general view there was that we are now seeing the worst financial crisis since the 1930s, however not that we are seeing the worst economic crisis since the 1930s," he told MPs on the finance and expenditure committee.
If the US housing market continued in deep decline for too much longer, retail banks, as opposed to investment banks, would start to take a hit and that would be more broadly damaging, he said.
The distinction between a financial crisis and an economic one was important to how central banks reacted, ANZ National Bank chief economist Cameron Bagrie said.
"If it becomes a question of financial stability, they have to move aggressively. It is critical to maintain or restore confidence." Otherwise the crisis could become self-perpetuating.
The deteriorating international environment was the big change since the last rate review, Bagrie said.
"It's not just a US problem. Europe has hit the wall as well and there has been a complete turnaround by the Reserve Bank of Australia within the space of four orsix weeks."
Bollard also cited domestic reasons for dispensing twice the 25-basis-point cut the markets had expected.
The economy was experiencing a "marked" slowdown, led by the household sector, while the business sector was also under pressure from rising costs and falling demand, he said.
The bank expects the June and September quarters to record "mild" contractions, following March's, but believes growth will pick up in the last three months of the year, as a result of tax cuts, increased Government spending, rising rural incomes and more supportive monetary policy.
"The timing of the [October] tax cuts does roughly meet a trough in household consumption. The timing works well, possibly better than expected when they were decided on," he said.
Its eyes on the medium-term horizon, the bank is easing aggressively though it expects inflation to hit 4.9 per cent in the current quarter and inflation expectations have crept up to 3 per cent even as the labour market remains "very tight".
But inflation concerns are taking a back seat.
"At this time we believe it is appropriate to lend more weight to the downside risks associated with the deteriorating global outlook, increased credit pressures and domestic housing market correction. However we remain mindful of the risks to inflation," the bank said in its monetary policy statement.
Westpac economist Michael Gordon said the bank was relying on weak growth to fix the inflation problem for it, creating an environment that made it hard for workers to negotiate larger pay increase and businesses to pass on higher costs.
"Our view for some time has been that they will be surprised by the inflation pressure."
Even with a very weak household sector - with consumption shrinking 1 per cent in the current March year and remaining feeble next year - the bank's own forecasts have inflation remaining outside its 1 to 3 per cent target band until the end of next year and remaining in the top quartile of the band through 2010 as well.
The dollar dropped by more than US1c in the wake of the rate cut and wholesale interest rates fell by some 20 basis points at the two-year point of the curve.
Having cut by 50 basis points, the markets now see about a one-in-six chance Bollard will deliver another 50-point cut at the next review on October 23.
Bollard emphasised that he wanted to see at least some of the OCR cut passed through to retail lending rates.
