All signs point to a 25 basis-point rate cut by RBA

Australia's economy is weaker than earlier thought and the Reserve Bank should cut the cash rate by another 25 basis points at the end of its board meeting today.

The major piece of new economic data concerns investment intentions, which have weakened both in the mining and non-mining sectors, and the labour market remains much weaker than suggested by an official rate of unemployment at 5.4 per cent.

The global outlook is little changed, but there is cold comfort in that conclusion.

The US economy seems to be recovering slowly, with stronger housing activity the latest positive news. But the US has a chronic problem of excessive national debt, and political gridlock about the solution. The default policies, if not amended, will cut spending and raise taxes and create a severe setback to economic recovery.

The eurozone economies are mired in even more intractable problems. Again excessive debt is the principal problem, but the deeper issue is the great contrast in competitiveness between the less indebted northern eurozone economies and the more indebted southern eurozone economies.

Unemployment rates are already at depression levels in the southern nations and there is no coherent plan to reduce their excessive debts.

Growth of China, India and other dynamic developing nations seems to be stabilising, although at slower rates of growth. Slower growth is a consequence of slower US growth and virtually zero eurozone growth, although China in particular is attempting, sensibly, a transition to greater reliance on domestic growth and less reliance on export growth.

The commodity prices Australia relies on for its prosperity experienced alarming reductions earlier this year but have recovered to levels that would justify current levels of mining investment and the continued stimulus expected from the third phase of the boom -- expanded quantities of commodity exports at prices highly satisfactory by historical standards.

It is worth noting a fundamental change in global monetary policy. In more or less uniform response of the major developed nations to the global crisis, central banks have adopted various forms of "quantitative easing". This builds on near-zero cash rates in these nations, and has resulted in a major expansion of the balance sheets of the central banks.

We are grateful to the newly appointed deputy governor of the Reserve Bank, Philip Lowe, for addressing some of the implications of this highly innovative development.

As Lowe put it in a speech in late October: "From one perspective, this setting of monetary policy is hardly surprising. The sluggish growth in many of the advanced economies means that little, or no, progress is being made in reducing high rates of unemployment. At the same time, core inflation is subdued . . .

"But from another perspective, what we are seeing is highly unusual. Since mid-2008, four of the world's major central banks -- the Federal Reserve, the ECB, the Bank of Japan and the Bank of England -- have all expanded their balance sheets very significantly, and further increases have been announced in a couple of cases.

"In total, the assets of these four central banks have already increased by the equivalent of around $US5 trillion, or 15 per cent of the combined GDP of the relevant economies. We have not seen this type of planned simultaneous very large expansion of central bank balance sheets before. So in that sense it is very unusual, and its implications are not yet fully understood."

Lowe discusses two implications of this "highly unusual" development.

The first is that it increases the prices of assets that the central bank is buying, thus lowering the yields on those assets. Thus bond yields in the US, Britain and Japan are all very low, and in the eurozone nations, whose bonds have been purchased by the European Central Bank, yields have retreated from the clearly unsustainable levels they had reached before the ECB began buying.

The second implication is that cashed-up institutions, including banks, at some stage will seek out higher-yielding assets, and their acquisition of those assets will drive up their price.

Expansionary monetary policy creates inflation but, with markets for goods and service depressed, it will be asset inflation that is the main immediate effect. Eventually, however, unless there is very deft and timely reversal of "quantitative easing", there will be a large burst of goods and services inflation.

This is not a conclusion drawn by Lowe but it is an issue we shall all be grappling with eventually. If it is commodity prices that are inflated most, Australia may even be a net beneficiary of what could a very dangerous risk to the stability of the global financial system.

The Australian economy is in a deeply uncomfortable state. According to the Roy Morgan survey of the labour market, the actual rate of unemployment is almost twice the official (Australian Bureau of Statistics) rate of 5.4 per cent. Small business everywhere is struggling, and the vital mining industry is facing strong cost-based headwinds.

Structural reform to boost productivity and reduce red tape and other impediments to doing business is desperately needed. But with goods and services inflation, including wage inflation, under control, the RBA should be keen to make its contribution to alleviating distress. A rate cut is all but certain today.