An economist explains why interest rate cuts are becoming less effective in Australia

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The RBA meets on Tuesday and after another weak inflation report many economists are now expecting another cut to the official cash rate by 25 basis points to 1.5%, which would be another record low.

One of the concerns about interest rate cuts as rates go lower, is that they start to become less potent as a stimulus measure for the economy.

We asked Joanne Masters, senior economist at ANZ, about this on our Devils & Details podcast this week and her explanation is a great summary of the issues.

Here’s an excerpt from Masters’ comments. You can hear it in the discussion at about the 30-minute mark below:

Interest rates are already low. You talk to anyone with a mortgage and they’ll say: “My rates are low; I can leverage up.” And we’ve seen that leveraging up. When I talk to businesses around the country, the cost of credit is not what’s prohibiting investment or capital expenditure if you like. Whether [interest rates] are at 2%, or 1.75%, or 1.5%, the difference is actually quite marginal. I guess that’s the first point. The second one is that household debt in Australia is really high. So low interest rates help in the sense that they reduce your mortgage payments, but what we’ve seen households do is actually not reduce their mortgage repayments. They’re actually paying off their debt faster. So there’s a rebalancing of their balance sheet, and that’s evident around the world. In a post-GFC environment, where there’s worry about your job security, that “dread risk” … is very much in play. So you’re cutting rates, and household aren’t actually spending it, they’re paying down their debt.

And of course the third thing is demographics. We have an ageing population, so increasingly as you get older, you have to have to have less debt and more savings and you rely on your savings to spend. And so when you cut rates, you actually hurt the spending capacity, or propensity to spend, of those retirees and of those older people. So all of those factors come in and they reduce the efficiency, or efficacy, of cutting rates at these levels.

Something that the RBA will be aware of when it meets on Tuesday morning to make its decision.

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