The Reserve Bank of Australia cut official interest rates to a record low this month. Just 1.25 per cent. And it has hinted they will do it again. It is “more likely than not” it will cut interest rates “in the period ahead”, the Reserve Bank said in official documents this week.
Several of Australia’s big banks now predict the RBA will keep slashing interest rates until they fall to 0.75 per cent. An amazing low, albeit not yet quite as low as in other parts of the world, where interest rates have fallen to zero and below.
Lower official interest rates will change all of our lives. The Australian dollar is likely to fall — and indeed it already has dropped below 70 US cents. It could go lower still. That will make imported goods more expensive and travel overseas dearer (which is the point — a lower dollar should make more of us buy Australian and holiday domestically).
If the official interest rate is cut, mortgage interest rates should get cheaper too. The banks are likely to pass on at least some of the cut the RBA makes. That will make it easier to pay off a mortgage, and leave borrowers more money to spend in the real economy.
Of course, if you have your money in a high-interest savings account, a rate cut is terrible news. If the banks pass on the rate cut to you, your money will earn less interest than before.
WHY DOES THE RBA FIDDLE WITH RATES, AGAIN?
Interest rates are like brakes on the economy. High interest rates slow down growth and cause inflation to be lower. When rates are high, people don’t borrow to spend. Instead they save. This is useful to slow down the economy when inflation is too high.
Cutting interest rates is like taking off the brakes. The economy speeds up and inflation starts to rise as people are more willing to borrow and spend now instead of saving. (When the RBA cuts rates, it hopes people will borrow to start businesses, not just borrow to buy houses.)
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The only real reason the Reserve Bank leaves the brakes on the economy is to stop inflation getting out of control. There’s absolutely no chance of that now.
Australia’s inflation is supposed to be between 2 and 3 per cent each year. But for the past few years it has been lower than that. The most recent reading is 1.3 per cent. They have been slowly taking the brakes off the economy for years now by cutting interest rates, as the next graph shows, and there’s not much more they can do before interest rates are at zero.
Lower interest rates should, in theory, help the labour market. Our unemployment rate has been rising in the past few months — to 5.2 per cent in the most recent data. That’s the opposite of what we want. The RBA reckons we need to get the unemployment rate below to 4.5 per cent before we start seeing inflation pick up. It hopes that by cutting interest rates, businesses will be more willing to hire people and expand, that wages will go up, and that we all become better off.
IT WORKS IN THEORY …
The risk, of course, is that this doesn’t work in practice. After all, interest rates have sunk lower and lower over the past eight years and look where we are. The RBA governor said this on Thursday: “The most recent data — including the GDP (gross domestic product) and labour market data — do not suggest we are making any inroads into the economy’s spare capacity.”
So it could be that we cut official rates to 0.75 per cent — or even lower — and we get more of the same from our lacklustre “meh-economy”. More weak wages growth. More low economic growth. More high underemployment.
If that’s the case, it will be time for even more desperate measures. We’ve used up almost all our interest rate cuts, but we still have a couple of boxes left, marked “Break glass in case of emergency”.
The best one is government spending. A big spending spree on infrastructure could be just what we need to keep people in jobs and make the economy tick over. That will mean we have to patient for a few more years before the Budget gets back to surplus, but if extra spending could save the economy from disaster, it would be well worth it.
Jason Murphy is an economist. He is the author of the new book Incentivology. Continue the conversation @jasemurphy
Originally published as Desperate action needed to save economy