By BOQ Chief Economist, Peter Munckton.
- The RBA kept the cash rate at 1.5% following its September meeting;
- The RBA view of the world remains broadly the same;
- The low cash rate continues to help the economy.
The RBA announced that it is keeping the cash rate at 1.5%. We are now into the 3rd year where monetary policy has remained unchanged. And we are on target for the cash rate to be kept at this level for some time to come. The Statement released following the Board meeting was very similar to that of preceding months. The RBA believe that the domestic economy was moving at an above trend pace in H1 2018. And strong exports, rising capex spending and public infrastructure spending should mean the economy will continue to do well. Despite all the noise, the RBA still appear comfortable with the global backdrop. The RBA names weak wages growth as a key concern. But even here they note there has been some signs of life. Overall, the RBA forecast of an improving economy and gradually rising inflation look to be on track.
Switching the channels
The current level of the cash rate in Australia is the lowest for at least the past fifty years. A significant factor behind the trend decline in the cash rate has been the fall of inflation. But even after allowing for the lower inflation rate, the (real) cash rate is still very low.
Very few borrowers actually borrow at the cash rate. In recent months there has been a rise in mortgage rates reflecting higher costs for banks from borrowing from the financial markets. But from a longer run standpoint borrowing rates are low (although they have risen a bit for some borrowers such as residential investors). The RBA notes that the average mortgage rate paid is lower than it was a year ago.
One thing that low interest rates does is encourage more borrowing. That did happen until around 2016. Subsequently total credit growth (particularly mortgages) has slowed. Banks have tightened lending standards (including by raising interest rates) as bank management and regulators became worried about how much household debt had risen relative to incomes. At the same time the supply of housing has risen substantially over the past year, alleviating the excess demand that had come from the substantial jump in population growth. These factors have led to slower house price growth (and declines in Sydney and Melbourne) making housing a less attractive place for investment.
Another thing that low interest rates does is improve borrowers’ cash flow position. Firms have been big beneficiaries of low interest rates, with the proportion of operating profits going to service debt at a very low level. The proportion of household disposable income spent servicing debt payments is well below its pre-GFC peak. But that ratio has increased a little over recent years (and is above the levels pre-2002). The recent (modest) increase in the proportion of household income going towards servicing debt repayments has mainly reflected the increase in the amount of debt borrowed by households.
Another positive of a lower cash rate is that it should reduce the value of the $A (thereby encouraging exports, reducing demand for imports and creating imported inflation). A key driver of the currency is the level of the Australian cash rate relative to that of other countries. The $A has declined in recent months, partially reflecting the expectation that interest rates will rise by more over the next 1-2 years in other countries (notably the US). From a historical perspective the $A on a TWI basis (ie, its value against all currencies weighted by the value of the trade Australia does) is a only a little below its long-term average. Ideally, the RBA would prefer the $A to decline a little further. Whether that happens depends upon not only the outlook for interest rates but commodity prices (the iron ore price is still relatively high) and the size of the current account deficit (has started to widen again after a period of being relatively narrow. As a result Australia needed less capital inflow to maintain the value of the currency).
One way that low interest rates leads to a lower currency is that it encourages savers to hunt for assets that provide higher returns offshore. In recent years domestic superannuation funds have reduced their allocation towards cash (including products such as bank deposits) and increased their allocation towards overseas assets.
All up, the low cash rate is doing what it is supposed to do. It has encouraged greater borrowing (although there is now some slowing in household borrowing) and improved cash flows. It has led to a lower $A. All of this has helped drive the economic improvement over recent years. With the economy moving in the right direction the overwhelming majority of economists expect the next change in the cash rate to be up. But inflation is still (marginally) below target. And wages growth is not high enough to lead to a sustained increase in household spending, or sustained higher inflation. For those reasons a large majority of economists expect no movement in the cash rate for some time to come. An unchanged cash rate (at 1.5%) remains the popular call until early 2020 (although a majority of economists expect higher rates in Q4 2019).
We are now into a third year where the RBA has kept monetary policy unchanged. At this time, the majority of economists don’t expect any RBA activity until sometime in the fourth year.
We live in interesting times.