RBA cuts interest rates to new record low

The Reserve Bank of Australia (RBA) has cut its cash rate to 1.5%. This means that interest rates charged and paid by banks should drop too.

The rate cut is the latest in a succession of cuts as shown by the chart below.

In the last four years the RBA has now halved its cash rate (3% to 1.5%). The aim of this expansionary monetary policy is to try and stimulate household consumption (C), business investment (I) and to some extent moderate the rise in the Australian dollar (AUD) to help maintain competitiveness in overseas markets. The rate cut will affect these variables via the monetary policy transmissions mechanism, although many doubt they will be that effective.

The reason that the RBA cut rates are given by their statement: extracts below.

"The global economy is continuing to grow, at a lower than average pace."
"Commodity prices are above recent lows, but this follows very substantial declines over the past couple of years. Australia's terms of trade remain much lower than they had been in recent years."
"In Australia, recent data suggest that overall growth is continuing at a moderate pace, despite a very large decline in business investment."
"Recent data confirm that inflation remains quite low. Given very subdued growth in labour costs and very low cost pressures elsewhere in the world, this is expected to remain the case for some time."

However there are some indicators that suggest that rates need not be cut. This is typical in any period and the RBA has to decide on the balance the forces to make its decision. They identify:

"Several advanced economies have recorded improved conditions over the past year..."
"Labour market indicators continue to be somewhat mixed, but are consistent with a modest pace of expansion in employment in the near term. "
"Low interest rates have been supporting domestic demand and the lower exchange rate since 2013 is helping the traded sector."

There are several concerns about monetary policy. These include will cutting rates at such low levels actually promote any change in behaviour, i.e. will cutting rates work? There is concern that the cut in rates simply shows how desperate the economic situation is and so any influence rate cuts have is overwhelmed by lower business and consumer sentiment.

There is also criticism that the RBA have badly mismanaged the situation for years and have failed to learn from other central banks. The Guardian article below explores this.

The ABC looks at the rate cut here

The Guardian discusses RBA policy here

VCE students will be interested in the conduct of monetary policy by the RBA and how this is likely to effect the Australian economy, in particular how it might work through the monetary transmission mechanism. Also the factors that are influencing Aggregate Demand in Australia are highlighted by this decision. IB students should also be interested in the RBA overall policy that is discussed in The Guardian ad how appropriate their actions have been in recent years given the time lags involved in policy and the influence of relative interest rates.

Better than expected inflation figure triggers significant reaction

Inflation is reported to be at 2.9% on the headline rate and 2.7% on the underlying rate. This is less than expected and has been a cause for relief for the RBA.

The RBA have a target range of 2 to 3% inflation. The widespread expectation was that headline inflation would rise to about 3.2% for the quarter to March and that this would cause the central bank to raise interest rates from their current low to reduce inflation.

The relief is on two counts.
1. A rise in interest rates would cause lower discretionary income for households and reduce Consumption. Also it would reduce Investment by firms which are sensitive to the cost of borrowing. Both are components of Aggregate Demand.

2. The exchange rate would likely rise as interest rates rose (Australia already has very high interest rates compared to the other industrialised economies). This would make exports more expensive and imports cheaper and stifle the export led growth on which much relies.

The news led to a sharp fall in the value of the Aus$ (by around 0.75 cents against the US$). This was due to traders lowering their expectations on the possibility of a rate rise.

It is well worth looking at the ABS statistics which can be accessed in the links section (key data). 

The likelihood is that rates will stay on hold for the rest of the year. This is good as business and consumers like stability. It gives them confidence and they can plan their next moves.

It is, however, unlikely that even 3.2% inflation would be the cause of a rise in rates. The RBA knows that it takes two years for interest rate changes to work through the economy to reduce inflation. They will be looking at the longer term forces affecting inflation over those two years when deciding on interest rate changes. So rates may rise anyway!