How low can our interest rates go?

THE Reserve Bank of Australia last week surprised this columnist with its rate cut. I, for one, was of the view that the RBA would be satisfied that the latest economic data has suggested we had turned the economic corner in Australia.

So it was certainly surprising that it did choose to cut rates a further 25 basis points. CommSec chief economist Craig James assesses the rate cut as being a case of “preventative medicine”.

“The patient may not be sick, but there is the real risk of infection from the global environment. In the current environment, there are few risks that the medicine being applied could lead to a new disease in the form of inflation,” he said.

This cut in rates is the fourth this calendar year. The cash rate now stands at 4.75 per cent. Since the start of this year, rates have fallen 1.5 per cent from 6.25 per cent. The current cash rate of 4.75 per cent is the lowest we have seen in 30 years. While the RBA is to be commended for focusing on the global economic picture in its decision-making, the comparison to central banks overseas is interesting.

In America, rates have been cut three percentage points, while in Canada they have fallen 1.75 per cent, 1 per cent in the UK, 0.75 per cent in New Zealand and 0.5 per cent in the Euro zone.

This highlights the issue I took up in a recent Business News column, when I referred to the reluctance of European central banks to aggressively cut their rates. It is this reluctance that is causing the world economy to remain very depressed. This then flows through into lower demand for our commodities and hence the poorer commodity price cycle that we are seeing now.

Since January of this year, the European Central Bank has cut rates only twice. The latest cut, which occurred last month, came about when it received news that Germany’s economy had stalled and that Italy and Belgium had contracted in the June quarter.

When you consider that there are expectations of a growth rate of 1.7 per cent in the next 12 months, it would seem almost a certainty that the European Central Bank will have to cut rates in the near future, again.

When you examine the reasons for the cut in rates it is self-evident that the global economic situation has been the main driver on this occasion. As a consequence of the global growth slowdown, the RBA has detected some weakening in export demand. The weaker global growth also has led to a reduced likelihood of inflation being an issue. The RBA was very positive on the domestic economic picture. It cited improved business and consumer confidence, firmer domestic demand and recovery in dwelling investment, which would ultimately lead to firm labour conditions in “due course”.

So the picture as far as the RBA was concerned was that, while there is a strong possibility of higher inflation in the short term, the longer-term picture was more positive due to the restrained growth in wages and a degree of spare capacity in the Australian economy.

Where do rates go from here? Mr James is of the view that we have reached a low point for interest rates in this cycle. He does, however, caution that the Reserve will maintain a bias to cut rates further if the global economy continues to weaken. Mr James also points out that: “The sub-text of today’s rate cut were the possible consequences should the US continue to cut rates and Australia stood pat. This could have led to a firmer Australian dollar at precisely the wrong time.

“The Reserve Bank would have feared a firmer Australian dollar at a time of weak demand and low prices. An Australian dollar back near US52 cents would not be a situation the Reserve Bank would view with any disappointment.”

What we can read into all of that is that it is unlikely we would expect to see another rate cut in this cycle. However, if the world economy continues its decline and the US Federal Reserve needs to cut rates further to try and stimulate its market, our Reserve could be drawn into having to match their cuts. Once again, our Reserve will need to be mindful of global conditions to determine our interest rate directions.

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