RBA Right To Cut, But Risks Remain
The Reserve Bank of Australia’s decision to cut the official cash rate has again typically had it fair share of critics. Some commentators suggest the RBA should not have cut rates as the economy is still travelling along relatively well, while others suggest the RBA has left its rate cutting efforts too late, which is why inflation is now too low for comfort.
My take is the RBA did what it needed to do, and at precisely the right moment.
We need to remember that RBA’s ultimate target is not inflation per se, but rather maximum sustainable economic growth and low unemployment. The RBA aims to maximise economic growth – and minimise unemployment. Simply going for short-term growth alone, however, risks allowing inflation to break out to troublesome levels, which in turn could disrupt economic growth and employment over the long-run.
So the RBA aims to maximise growth subject to a constraint – namely that inflation is not allowed to consistently move above or below a 2 to 3 per cent range. If inflation is a non-binding constrain, as it is at present – and we retain spare capacity in the form of a higher than necessary level of unemployment - the RBA can afford to set its sails for stronger growth, even if the is still far from recession.
This is exactly what the RBA argued in its latest (August) Statement on Monetary Policy. It said “while the prospects for economic growth are positive, there is room for even stronger growth.”
In other words, low inflation afforded the RBA an opportunity to encourage the economy to growth at an above-trend pace, such that we might expect a decent decline in the unemployment rate ( to 5% or less) and a lift in wages growth to levels more consistent with the RBA’s long-run 2 to 3 per cent inflation target.
The June quarter CPI result did not need to be lower than the RBA was expecting to justify the latest rate cut. Merely the CPI needed to confirm that annual underlying inflation was as low as the RBA thought it would be – namely at 1.5%, the same as in the March quarter.
You may not agree with what the RBA is up to, but this is the best way to understand what it is doing.
The RBA is not necessarily expecting to get inflation up anytime soon. Nor is it unduly worried about the economy. Rather it simply feels that it has the ability to help reduce unneeded spare economic capacity – without risking overly high inflation – then it should do so. And given the RBA expects inflation to remain very low for the one to two years, there’s a good chance it will feel the need to cut rates further.
Of course, that then opens up two other debates. First, are low interest rates really having any effect in boosting economic growth? Clearly, low interest rates are not having the effect they once did: highly indebted households are more cautious about spending and are just as likely to use lower interest rates to pay down debt more quickly. And it’s also true our swelling ranks of retirees mean more households are dependent on interest income, which clearly falls as interest rates fall.
But on balance, the RBA feels – rightly in my view – that the net impact of lower interest rates is stimulatory. After all, with interest-bearing deposits taking up a smaller share of household balance sheets (in preference to equities and property), households are still net-payers of interest.
Lower interest rates also have other important effects – such as helping boost the value of housing and equity wealth (the “wealth effect”), and also making trade-exposed industries more competitive by helping place downward pressure on the $A.
What’s more, if interest rates have less impact on spending these day than it used to – this is arguably and argument to cut rates even more, rather than less.
Although the economy is not booming, moreover, despite lower interest rates – we also need to appreciate the counter-factual. Where would the economy be – such as housing and the Australian dollar – were official interest rates back around 2.5% in a world where of near-zero interest rates in many other parts of the world.
The other argument against lowering interest rates is that it could create destabilising asset price bubbles. This is a good argument, but the RBA now feels (again, correctly in my view) that so-called “macro-prudential” controls are helping to stem excesses in the heated Sydney and Melbourne markets, while bubble concerns (so far at least) are much less evident elsewhere.
That of course leaves the share market. And with price-to-earnings valuations for the S&P/ASX 200 now reaching the top end of their range for the past decade or so, there may well develop concerns that the RBA could be encourage an equity valuation bubble if interest rates stay a lot lower for longer. Valuations for high income defensive sector of the market – like consumer staples and listed property – are reaching nosebleed levels.
To my mind, a potential share market bubble is the biggest risk associated with the RBA’s current approach. But unlike in the case of property, share prices are also driven by global events. And central banks around the world are also at risk of creating share market bubbles unless they change their ways.
David is one of Australia's leading economic and financial market analysts. His is Chief Economist with BetaShares, and an Economic Advisor to the National Institute for Economic and Industry Research (NIEIR). His has held former roles as senior commentator with The Australian Financial Review, Macquarie Bank interest rate strategist and Federal Treasury economist. He is also author of the online e-book, TheAustralian ETF Guide.