Interest rate cut ‘sowing the seeds of disaster’
The Reserve Bank cut interest rates to a record low of 1 per cent today — but the Government is playing a risky game that might end in recession.
JULY 2, 20195:01PM
The Reserve Bank of Australia is spending its ammunition, cutting interest rates to just 1 per cent, in a desperate attempt to breathe life into the Australian economy.
After an extremely long stretch during which the central bank insisted things looked good, and that the next move in interest rates would be up, it changed its mind sharply. The bank cut rates last month and again today, meaning rates have fallen from 1.5 per cent to 1.0 per cent since the election.
Interest rates have been slashed to a record low. Picture: SuppliedSource:Supplied
Announcing the interest rate cuts on Tuesday afternoon, the Reserve Bank said the cut would help make “faster” progress in reducing unemployment and spare capacity in the labour market.
The bank better hope its cuts work. Because with interest rates at 1 per cent, it can only make four more usual-sized cuts before rates are at zero. And it is not easy to cut interest rates below zero.
WHY DO WE PLAY WITH INTEREST RATES?
Interest rates help control economic growth. If you want faster economic growth — as we do now — you need to cut interest rates. The idea is that if the interest rate on borrowing money is low, people will borrow more to invest in businesses, or to spend up at the shops. That makes the economy go round.
Australia’s economic growth is just 1.8 per cent, and we have rising unemployment, high underemployment and low wages growth. Household debt is very high, meaning people are reluctant to spend up big. Lower interest rates should help make us spend more.
With lower interest rates we will also be less likely to save, because the interest rate on our bank accounts is lower. So, in theory, we spend that money instead. In this way, low interest rates are supposed to make the economy run faster, getting more people into work and lifting wages growth.
The only reason we don’t usually keep interest rates at crazy low levels is it makes inflation dangerously high.
That’s not a problem right now. We have low inflation — just 1.3 per cent. Low inflation is something the central bank tries to avoid. The RBA does not aim at economic growth directly. They normally focus on inflation, which is high when growth is high and low when growth is low. At the moment we have low inflation and low economic growth.
The central bank would like inflation to be back in the range of 2 to 3 per cent — not because inflation is terribly good — but because it’s a good way of making sure the economy is growing at the right speed.
The RBA is hoping the latest rate cut will help people spend up big. Picture: SuppliedSource:istock
WHAT HAPPENS NOW?
Interest rate changes normally don’t work immediately. But the effect of these interest rate cuts might be seen in housing markets as soon as this weekend. House prices are already slightly rising, according to CoreLogic data, and buyers might soon start getting FOMO — the fear of missing out.
ANZ and Westpac passed on only part of the last round of interest rate cuts and the RBA will be pressuring them to pass on the next round. RBA Governor Philip Lowe specifically mentioned on Tuesday that their usual excuse of high funding costs no longer applied
“Bank funding costs in Australia have also declined, with money-market spreads having fully reversed the increases that took place last year,” Governor Lowe said.
If banks pass on the cuts, mortgage repayments should fall and that will leave mortgage holders with more money in their pockets. That can only be good for retail spending, and in turn good for the economy.
We now have record low interest rates, rising house prices and a scheduled tax cut of $1080 for middle income earners in the second half of the year. Could that be to breathe some life back into the Australian economy?
The Governor of the Reserve Bank of Australia Dr Philip Lowe. Picture: Bianca De Marchi/AAPSource:AAP
IS THAT ALL WE NEED TO DO?
There are still risks. The RBA has done its job, now it is time for the Treasurer to do his. The economy needs support from all angles. If the Treasurer Josh Frydenberg leaves it all up to the RBA, he is likely to find the economy falling to pieces around him.
The Bank for International Settlements (central bank of central banks) just this week put out a big report saying if you depend too much on monetary policy (e.g. interest rate cuts) to fix your economy, you may be sowing the seeds of the next disaster.
“There are diminishing returns and costs in relying too much on monetary policy,” The Bank for International Settlements said. It recommends reforming the economy and “boosting well chosen infrastructure investments”.
What that means in practice is that we need to stop worrying only about whether interest rates get tweaked up or down by 0.25 percentage points. We need big bold plans to make Australia’s economy strong.
After all, mortgage holders are not the only people that can borrow at low interest rates. The Government can borrow at low rates too.
If it wanted, and if it had the vision, it could use this opportunity to transform the country’s future.
Jason Murphy is an economist. He is the author of the new book Incentivology. Continue the conversation @jasemurphy
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