ANZ explains why record-low interest rates in Australia aren't as stimulatory as they appear

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If you’re expecting Australian interest rates to shoot higher in the years ahead, be prepared to be disappointed. According to new research from ANZ, the Reserve Bank of Australia’s “neutral” cash rate is now significantly below the 5-6% level seen before the global financial crisis.

“We estimate that the neutral nominal cash rate has fallen from a pre-global financial crisis range of 4.75-5.75% to a post-crisis range of 2.25-3.25%, reflecting wider bank spreads, a lower world neutral rate and a lower potential growth rate,” says Kieran Davies, an economist at the ANZ.

“This compares with the RBA’s pre-crisis estimate of 5-6% and a post-crisis estimate of 3.5-4.5%.”

The neutral cash rate is the level which would allow the Australian economy to grow at trend without stoking inflationary pressures.

The chart below reveals the estimates for Australia’s neutral cash rate level, comparing the RBA’s view to the ANZ’s. While the RBA’s take hasn’t been updated since 2012 publicly, Davies suggests that its likely the bank has downgraded its assessment in private.

Davies estimates that increased spreads between the RBA cash rate and borrowing rates to the private sector largely explains the decline in the neutral cash rate level, accounting for 175 or the 250 basis point revision made by the bank.

A downgrade to Australia’s trend growth level, now deemed to be around 2.75%, along with a lower neutral policy rates globally, account for the remaining 75 basis point reduction in his opinion.

“The spread between the mortgage rate and the cash rate is expected to stay high and may widen further given sustained pressure on bank funding costs,” says Davies.

“Our rates strategy team believes that the next phase of regulatory change will likely reinforce a structurally higher backdrop for funding costs as the funding mix for banks shifts to more expensive sources.

“They also caution that the ongoing evolution of regulatory changes may raise the cost of funding to banks, and thus lending, over time.”

The chart below, again from ANZ, shows the spread between the RBA cash rate and Australian mortgage rates.

Given borrowing rates to Australia’s private sector have fallen by a smaller amount than official interest rates, Davies suggests that the cash rate — currently sitting at a record-low level of just 1.75% — is delivering less stimulus to the Australian economy that what would have been the case in the past, underlining why the RBA has lowered the cash rate by 300 basis points since 2011 to help buttress the economy from the effects of the diminishing mining infrastructure boom.

“This makes us more comfortable with our forecast that the Reserve Bank will cut rates again to 1.5% given weak underlying inflation, keeping the cash rate low over our two-year forecast horizon,” he says.

With interest rates already at record-lows, and expected to fall further, Davies suggests that this could open the door to a sub-1% cash rate in Australia in the advent of a renewed economic crisis, something that may lead the RBA and other regulatory authorities to use increased macroprudential measures to prevent excessive risk-taking by investors.

“Sustained low interest rates could have unintended and/or undesirable consequences. Low rates should underpin a structural shift in asset price valuations, but may also encourage investors to take excessive risks, particularly in the housing market,” notes Davies.

“Such a situation could force the Reserve Bank to reluctantly rely more on prudential policy, where the reluctance stems from concerns that prudential measures could also have unplanned and/or undesirable consequences.”

In other words, should lower interest rates arrive in the future, recent restrictions imposed by Australia’s banking regulator, APRA, to cool lending to housing investors may be only the start of greater macroprudential measures to come.

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