By Michael Witts

What do rate cuts do to help the economy? Do they have the same impact now?

On the surface you can argue that lower interest rates help the economy, however, as with all things the devil is in the detail.

There are three key considerations in addressing this question:

  1. The absolute level of interest rates. For example, a 25 basis point cut at 8% has a more significant impact than a similar drop at lower levels. Also, is the rate cut the first in a series or is the trend in rates more established?
  2. The relative proportion of borrowers and investors in the economy. For example, currently only about one third of the population benefits via lower mortgage rates following a cut in the cash rate, whereas a significantly larger proportion of the population is impacted via lower deposit rates.
  3. What the borrowed money is being spent on. For example, currently there is more funding going into buying established houses as opposed to the construction of new houses.  In this scenario the flow-on effect from construction activity is lost.

In general I think it is fair to say that the lower the absolute level of interest rates, the less effective monetary policy (ie. interest rates) is as a tool to re-ignite economies.

Therefore, in the current low interest rate environment, monetary policy is less effective. If you think about a business development project, it is highly unlikely that the decision to proceed or not will be heavily influenced by interest rates being at 2% or 2.25%, or for that matter at 2.5%.

What were the reasons behind yesterday's rate decision?

The RBA left the cash rate unchanged at yesterday’s meeting. While financial markets had aggressively priced a cut of 25bps, economists where more mixed.

The RBA re-stated its concern about the level of investor activity in the Sydney property market. Prior to Easter, the auction clearance rate in Sydney was almost at 90% - a very strong outcome - especially in line with the very high volume of properties on offer. 

The RBA again re-stated that it continues to work with other regulators to assess and contain risks that may arise in the housing market.

In opting to leave the cash rate unchanged the RBA did note that further easing may be appropriate over the period ahead.  It was also noted that the $A has declined against the USD over the past year - indeed the $A was at almost 95 cents, compared with around 76 cents prior to the RBA statement.

It appears that the economy may be finally coming through the transition phase, as past rate cuts and stronger housing activity are translating to stronger economic numbers. Yesterday’s retail trade and car registrations were at the top side of expectations.

Should we expect more rate cuts this year?

While the RBA indicated that it has the capacity for a further rate cut or cuts; it appears to be increasingly in a ‘wait and see’ mode. 

The release of the March quarter CPI in late April, ahead of the May RBA Board meeting, will be the next focal point that markets will gravitate towards. However, the CPI will be a low number due to oil price movements.

Yesterday’s unchanged cash rate may signal a realisation that the effectiveness of monetary policy is increasingly being questioned.  The Federal Budget in May will provide opportunity to deliver policy outcomes that are beyond the scope of monetary policy. In particular, policy directed towards regional growth would perhaps be more effective at this stage of the cycle.

Has the RBA changed its view on the Australian economy and the Australian dollar?

The RBA appears to be suggesting that it is increasingly comfortable with the speed and strength of the transition underway in the Australian economy. The key driver for the economy and monetary policy in the period ahead will be the extent to which fiscal policy can shoulder some of the adjustment process.

In relation to the $A, although the RBA still argues for a lower $A , it at least acknowledges that the currency has moved lower over the past 12 months.

It appears that the RBA may be starting to acknowledge that interest rates have minimal, if any, impact on the price of specific commodities, therefore constantly arguing that the $A should be lower because of lower commodity prices and terms of trade is in itself somewhat futile.

The important driver for the $A over the period ahead will be the strength of the US dollar, as the US Federal Reserve moves closer to returning US interest rates to more normalised levels. 

And the global economy?

The RBA sees the global economy continuing to head towards a more balanced outlook. The US continues to lead the way, and China’s economy remains impressive, even if lower than last year.

There appears increasing evidence that European growth is starting to respond to the significant and varied stimulus programs of recent years. The caveat to the European outlook is a series of key dates in terms of repayments for the Greek economy. Failure to meet any of these payment deadlines could result in renewed speculation as to the future of Greece in the Euro.

What is ING Direct’s view on the economy and the Australian dollar?

In leaving rates on hold yesterday, we believe the RBA got it right.

There is momentum in the economy, and although growth may be uneven across the economy, monetary policy is not necessarily the most effective or efficient policy instrument to address these differing issues.

A rate cut yesterday would have provided further fuel to an already red-hot Sydney property market and in the event of a hiccup in this sector the impact on the broader economy would be significant.