Australia’s central bank has joined Europe and Japan in slashing official interest rates to new record lows. Just how much further could they fall?
On August 2, the Reserve Bank of Australia (RBA) responded to weak inflation by pre-emptively cutting its official cash rate by 25 basis points to 1.5 percent, a new record low for the world’s 12th largest economy.
The move followed June quarter data showing consumer prices increased by just 1 percent over the past year, the weakest annual rise since 1999 and well short of the RBA’s target range of 2 to 3 percent. Wages growth also hit an 18-year low in the March quarter, adding to soft inflationary expectations.
RBA Governor Glenn Stevens said the latest rate reduction would improve the prospects for sustainable growth, following below-average global output, lower commodity prices and mixed labor data. Conditions have also worsened for emerging market economies including China, where “the underlying pace of China’s growth appears to be moderating,” he said.
“Recent data confirm that inflation remains quite low. Given very subdued growth in labor costs and very low cost pressures elsewhere in the world, this is expected to remain the case for some time,” Stevens said.
Stevens also indicated that lower interest rates had helped support domestic demand and weaken the exchange rate, with an appreciating exchange rate threatening to “complicate” the economy’s transition to non-mining sectors post the resources boom.
However, if the move was aimed at the exchange rate, it only had a limited effect. After dropping by half a U.S. cent following the announcement, the Aussie dollar quickly bounced back to be almost its level ahead of the cut, at around 75.25 U.S. cents.
But with most economists expecting an interest rate cut, AMP Capital Investors economist Shane Oliver said the currency would have seen a sharp appreciation had the central bank not taken action.
“With the inflation numbers so low and the risk that if they didn’t cut that the Aussie dollar would have been 76-77 [U.S. cents] by now, they felt they probably had to act,” he was quoted as saying by ABC News.
OECD economist Adrian Blundell-Wignall told the Australian national broadcaster that the RBA had no choice in slashing rates, amid a global search for higher-yielding assets.
“You can’t be totally impervious to what markets are doing, and what they’re searching for when yields have been driven down to zero or negative numbers. What other countries do affects us and so that becomes a part of our own tool kit as well,” he said.
Other economists have warned that the official rate could fall as low as 1 percent by 2017, to stave off deflation and keep the Australian dollar from appreciating.
In its quarterly statement released Friday, the RBA highlighted the pressures facing central banks in the global race to the bottom on rates.
“Globally, monetary policy continues to be remarkably accommodative and, for most jurisdictions, market participants generally expect it to remain so for an extended period or to become even more stimulatory,” the bank said. It noted the Bank of Japan’s latest stimulus measures and anticipated further easing by the European Central Bank and the Bank of England.
“Market expectations for the US federal funds rate have declined over the past few months such that the next rate rise in the United States is not priced in until late 2017,” it said.
However, the RBA said it still expected gross domestic product (GDP) growth of around 2.25 to 3.5 percent in 2016, increasing to around 3 to 4 percent by 2018, while underlying inflation is expected to post only a gradual pickup to 2 percent in two years.
Australian Financial Review contributor Christopher Joye said the next step for the RBA after reaching the 1 percent level could be joining its developed economy counterparts in adopting quantitative easing (QE).
“If core inflation stays below the RBA’s target, more cuts could come our way – I don’t think the 1 per cent barrier will give them much pause,” he said.
“In contrast to 2012, the RBA probably has greater confidence in its ability to utilize alternative tools like quantitative easing, which has become de rigueur around the developed world. This would involve revving up the RBA’s printing press to buy Australian government bonds, mortgage-backed securities and conceivably other corporate bonds to reduce medium- and long-term risk-free rates and the cost of debt more broadly.
“Doing so in a downturn would give the government conviction to ramp up deficits without fear of the consequences of losing Australia’s AAA credit rating (since the RBA would put a ceiling on the cost of the government bonds that finance this spending). In this way fiscal policy could take more of the counter-cyclical burden away from monetary policy.”
However, the benefits of cheaper rates for borrowers can be reduced by the interest income losses faced by savers. There is also evidence in nations such as Japan, with official negative interest rates, of banks levying higher fees to overcome income losses, according to Joye.
An alternative to ever-lower interest rates is a demand boost through a “weaker currency or fiscal policy,” according to Macquarie Bank economist James McIntyre.
Morningstar’s head of equities research Peter Warnes has also linked the problem to weak demand.
“Since late 2007, the U.S. Federal Reserve has cut the federal funds rate from 5.25 percent to 0 to 0.25 percent before lifting to 0.25 to 0.5 percent in mid-December 2015. It has sat pat since. In addition, the Fed added several trillion to the U.S. monetary base. Last week’s disappointing GDP data is not a great outcome for eight years of work,” he said.
“European and Japanese central bankers are still stimulating and printing money, with the economic body unresponsive to multiple procedures. While the stimulus has not been as effective as hoped, no doubt we would be in worse shape without it. Remember Europe’s failed austerity experiment anyone?
“While [Australian Treasurer] Scott Morrison and central bankers focus on trying to stimulate inflation, wages growth and business investment, they are missing the point. The focus should be on stimulating demand. In the absence of an unlikely surge in wages, inflation is unlikely to be revived if demand is flat lining. Increased demand is the most productive way to eliminate excess capacity.”
He added: “Lower interest rates may help the share market and housing prices but these are not a productive use of monetary policy given both have been major beneficiaries of global stimulus over the past five years. In fact, the law of diminishing returns comes into play.”
Japan’s two-decade battle with deflation has led to calls for a coordinated approach, including the use of fiscal and income policy tools, rather than simply relying on ever-cheaper credit.
For governments fighting deflationary pressures, leaving it all to monetary policy no longer appears a valid option, even in the “Lucky Country” of Australia.