Expect the cash rate to fall to 2% in the months ahead.

The RBA was right to cut interest rates again. Growth is too low and inflation is benign. Expect the cash rate to fall to 2% in the months ahead. Record low borrowing rates, the lower $A and the boost to spending power from lower fuel prices should help boost growth to 3% or just over into next year.

Introduction

Ever since commodity prices and the mining investment boom peaked 3 or 4 years ago there has been a constant chorus of doom regarding the Australian economy: the reversal of the mining boom will knock the economy into recession, house prices will crash and banks will tumble. This view was particularly prevalent amongst foreign commentators who seemed to think that resource extraction was the only thing Australians do. While this tale of doom has not happened, the economy has been a bit lacklustre: growth has been sub-par, wages growth has fallen to record lows, unemployment has drifted up and confidence readings have remained poor. Against this background, the RBA has rightly cut interest rates again. This note looks at the key implications.

Interest rates and the economy

There are good reasons for the RBA to be cutting rates further: Growth is too low, running at around 2.75% through last year, which is well below potential (of around 3-3.25%) and the level needed to prevent a rise in unemployment. Confidence is subdued, having well and truly given up the post 2013 Federal election boost.


Source: Bloomberg, AMP Capital

Partly reflecting this, consumers have started to become more focused on paying down debt again, which is a sign of increasing caution and will threaten spending if sustained. Australia's becoming a bit more cautious again

Source: Westpac/Melbourne Institute, AMP Capital

Prices for iron ore and energy have collapsed resulting in a bigger hit to national income than expected a year ago. Iron ore and the terms of trade has fallen more than expected


Source: Bloomberg, AMP Capital

Outside the US the predominant trend globally is still towards monetary easing and this is putting pressure on the RBA. Massive quantitative easing programs in Europe and Japan are forcing smaller countries to ease unless they want to see their currencies go higher. This should really be characterised as “easing wars” as opposed to “currency wars”. To the extent it is forcing monetary easing around the world, it adds to confidence that sustained deflation can be avoided.

Australia is not immune. As the RBA wanted to see a continued broad based decline in the value of the $A it had to re-join the easing party lest the $A rebounded. Our interest rates are still high globally. Finally, benign inflation provides flexibility for the RBA. The main risk in cutting rates again is that it further inflates the residential property market. However, strong property price gains are largely concentrated in Sydney and the RBA sees this as more of an issue for the prudential regulator, APRA.

Overall, we see the RBA’s cut as justified and, given that there is rarely just one move, we expect another 0.25% cut taking the cash rate to 2% in the months ahead.

To read the rest of this article, please click here

Related Articles