Fears of the damage to the Australian economy from the turmoil in world financial markets in the wake of the failure of Lehman Brothers and a spate of other banking problems, including a possible rationing of credit by Australian banks, helped convince the Reserve Bank board to cut rates by a larger than expected 1% at its last meeting on October 7.

The RBA warned in the minutes of “downside risks to the economy” from the worsening global conditions, singling out a possible worsening in employment and business investment in the months ahead.

Statistics suggested that the slowing was most pronounced in NSW compared with elsewhere in Australia, though the employment data by state were quite volatile. Job advertisements had been falling over the past six months, with newspaper job advertisements sharply lower. This suggested further slowing in employment was in prospect.

Business investment had increased by 10 per cent over the year to the June quarter, but the outlook was now more uncertain. Despite the positive intentions reported in the capital expenditure survey, private-sector business surveys suggested that investment plans were being scaled back.

The minutes were released this morning as the stockmarket enjoyed its second solid day of trading, with a rise of more than 2% in morning trading, after a 4% rise yesterday and the Australian dollar was around 70 US cents.

The release came as the National Australia Bank reported a lower profit for the 2008 full year, as forecast, but warned that the next year would feel like a recession, but would actually see growth at around 1%, according to retiring CEO, John Stewart.

Major retailer, Woolworths, released solid first quarter sales figures showing stronger same store growth across its vital food and liquor business of 6% and top line growth of 8.3% for the division and 9.6% for the group as a whole (including New Zealand).

And the country’s biggest furniture, consumer entertainment and IT retailer, Harvey Norman, reported a worsening in its sales in the week to Sunday. Last week it reported a drop in same store sales of 4.7% for the four weeks to October 12. This morning it said that in the four weeks to October 19, same store (or like for like as Harvey Norman describes it) sales had slumped 5.8%. Harvey Norman has undertaken to update these figures for the next three weeks.

As the global credit crunch morphed into a global credit freeze in the wake of the collapse of Lehman Brothers and the other bank bailouts and mergers, the RBA initially looked at a half a per cent cut in the cash rate, but left itself the room by to cut by more, as the minutes revealed:

The paper prepared for the Board recommended a large reduction in the cash rate, of at least 50 basis points, with the amount to be subject to review in light of any events occurring between the preparation of the paper and the time of the meeting. In the event, the recommendation put to the Board at the meeting was for a reduction of 100 basis points, to 6.0 per cent.

The bank was worried however that such a large rise might spark further pressure on the already weak dollar, but went ahead anyway

The Board considered the possibility that a larger-than-expected easing of 100 basis points could have a negative effect on market sentiment. The exchange rate in particular had fallen sharply over the preceding 24 hours. Members concluded that, despite the possibility of a short-term adverse reaction, stronger action would help sentiment over time.

The minutes confirm that the RBA also cut rates to get the largest possible pass through of the reduction to borrowers.

As staff estimates suggested that banks’ funding costs had risen by about 20–25 basis points relative to relevant benchmarks, any reduction in interest rates that banks announced on loans to customers would most likely be less than the change in the cash rate by a similar margin.

Members discussed the implications for banks’ lending rates of market expectations of official rate cuts this month and later in the year, noting that market expectations were for the cash rate to reach 5½ per cent by mid 2009. They were informed that staff estimates suggested that banks’ funding costs had risen by about 20–25 basis points above relevant benchmarks. Banks were still keenly bidding for deposits across the yield curve.

One of the consequences of the conditions facing banks was that there was a likelihood of tighter quantitative credit conditions in the period ahead.

But overall, the factors behind the largest rate cut since May 1992 were summed up in this quote from the minutes:

The key factors for members’ consideration were the sharply worsening conditions in international financial markets during September and the consequential deterioration in the global economic outlook. Prices in global asset markets had fallen sharply and growth in credit in the major economies had slowed to unusually low rates. These developments meant that households and businesses in many countries would have difficulty accessing funding and that global economic activity, which had already slowed significantly, would probably slow further.

Members noted that forecasts of growth in GDP in both developed and developing economies were, therefore, in the process of being revised down, particularly for 2009. Members also noted that Australian financial markets were being affected to a lesser extent than in many other countries, given the relative strength of the domestic banking system. Nonetheless, the deterioration in the outlook for global economic activity posed downside risks to the domestic economy.

That’s why the rate cut was 1% and not 0.50%.