First the good news – RBA interest rates could fall as low as 1.5%.
The bad news – the economy needs the cuts.
That’s the conclusion of a new research report from Credit Suisse research analysts Damien Boey and Hasan Tevfik titled A strong case for more RBA rate cuts.
Boey and Tevfik make the case that RBA interst rates “are positively correlated with business and consumer confidence, and inflation expectations. Rates are negatively correlated with unemployment.”
That being the case they say that:
Leading indicators suggest that a case can be made for further cuts. Confidence is low and consistent with weak growth. Inflation expectations are falling and the unemployment rate is rising. Also, mortgage principal repayments are rising, as interest-only loans reset. All factors point to lower rates. Our model suggests that rates could fall to 1.5% over the next year.
Boey and Tevfik argue that the consensus which says that 2.5% is the lower bound for RBA rates is wrong and that the RBA is not a model-based central bank but rather takes a “pragmatic” approach to setting rates based on “the balance of risks to growth and inflation, rather than relying on accurate forecasts of where GDP growth is headed.”
This allows Boey and Tevfik to model the RBA’s behaviour based on their identified inputs which have high correlations with movements in interest rates.
Cash Rates and Confidence =>lower rates
Cash Rates and Inflation expectations => no move
Cash Rates and Unemployment => lower rates
Cash Rates and Household debt levels and servicing => lower rates
Tieing it all up into a model => Rates to 1.5%
Currently, the model is suggesting that rates need to fall slightly below 1.5%. Just over 100 bp worth of rate cuts is appropriate for the times.
This is because:
Private sector confidence has declined to below-average levels consistent with weak growth. The unemployment rate has risen to a cyclical high of 6.2% and is still increasing, consistent with rising spare capacity and subdued inflationary pressure. Inflation expectations have dropped to a little more than 2%, in part because of a global slowdown. Mortgage principal payments have continued to trend higher as a share of income.
Boey and Tevfik are not forgetting the impact of Sydney house prices and note that house price rises appear to have re-pointed the RBA toward financial stability. But, they say, while this is difficult to model their conclusions and forecasts are not materially changed when accounting for the RBA’s concerns.
Summing up they say that with consumers defensive and paying down debt rather than spending on discretionary items, business is not in a mood to invest “because they have had no real need to do so in a soft demand environment.”
So Australia is left with “anaemic growth, rising spare capacity, disinflation and ultimately lower rates”.
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