The Reserve Bank will almost certainly be cutting the cash rate to a record low 2.5 per cent today. The ‘record’ low covers all the data from the Reserve archives that go back to 1959, when the bank was separated from the Commonwealth Bank to conduct central banking functions, including in the modern terminology, setting monetary policy.
These record low interest rates are due to many factors, and outlined below are the key reasons, in no particular order, why the Australian economy is about to get interest rates never before seen.
Global interest rates are at the lowest levels in more than a century. Most industrialised countries have set interest rates at level at zero, or as practically possible near zero, based on the parlous positions of their economic conditions. Australia is part of the global economy and the downdraft from a softer industrialised world together with very low global inflation is being felt here in Australia.
Falling terms of trade:
Global economic conditions are also showing up in slower economic growth in Australia’s major trading partners and China in particular. This softer economic activity in Australia’s main export markets has driven falls in commodity prices since their peak during 2011, which in turn is eating away at national income. While the end point of this weakness is the centre of the current debate, these softer economic conditions pose a threat to the terms of trade which are expected to fall further over the next couple of years. The chart below shows the latest Treasury forecasts.
Growth below trend:
The recent economic data has confirmed that Australia’s annual GDP growth is running at around a 2.5 per cent pace. This is about half to three-quarters of a percentage point below the long-run trend, the consequences of which is a slow but steady build up in spare capacity. That extra spare capacity is showing up in the capacity utilisation measures and in the gentle rise in the unemployment rate. Easier monetary policy will help support spending and investment, as well as working to push the Australian dollar lower, which are all essential ingredients if GDP growth is to lift back above 3 per cent.
Tight fiscal policy:
Despite the softening in revenue into 2013-14 and the slight widening in the budget deficit forecast in that year, fiscal policy has been tightened. At the Commonwealth level, the budget deficit has fallen from a peak 4.2 per cent of GDP in 2009-10 to a deficit of 1.3 per cent of GDP in 2012-13, a period which saw government spending fall 1.8 per cent of GDP. Fiscal policy at the state government level has also been tightened to the point where public final demand cut a massive 1.5 percentage points from GDP growth in 2012-13. In other words, as public demand has been falling, there is a need for easier monetary policy to boost private sector demand. As the government likes to put it, the fiscal tightening has made room for the Reserve to have accommodative monetary policy settings.
Triple-A credit rating:
While probably more relevant to the bonds market, Australia’s triple-A credit rating with a stable outlook from all three major ratings agencies has made global investors very comfortable buying Australia assets. Indeed, there is a simple but direct correlation between a countries credit rating and the level of interest rates, although central bank intervention in bond markets in more recent times has somewhat distorted this link. Countries with a poor credit rating often have to set very high interest rates to attract capital inflows – Australia has the opposite problem.
The June quarter consumer price index confirmed inflation running in the bottom half of the Reserve Bank’s target band. If economic growth remains sub-trend and had the Australian dollar stayed high, there was a strong probability that inflation would fall below the bottom of the target band. Indeed, the Reserve has been consistent over the past year, reiterating the fact that ongoing low inflation outcomes were providing the scope it needed to easy monetary policy.
Soft labour market conditions:
There has been a gentle uptick in the unemployment rate and wages growth has slowed as economic growth has cooled over the first half of 2013. It is often overlooked that the Reserve Bank’s mandate includes a ‘full employment’ objective and as the unemployment rate has been ticking higher, interest rates have been ticking lower. With the forward indicators of labour demand – ANZ job ads and the job vacancies series – still slowing, it is likely that the unemployment rate will rise in the months ahead, which is something the Reserve will be keen to minimise.
A critical factor behind low inflation and the speed limit at which an economy can growth is productivity. On that score, Australia is doing well with a solid 5 per cent gain in productivity over the last two years. This is underscoring the growth potential of the economy and is a critical element in helping to keep inflation low and the potential growth rate high.
Clearly then, there are many reasons why interest rates in Australia are at record lows and over the past few years, the importance of each issue has waxed and waned according to fresh information. It is not all that helpful to focus on any one issue – rather to do what the Reserve Bank does each month and look at a broad range of indicators which at the moment suggest lower interest rates are indeed needed.