The Reserve Bank of Australia (RBA) is widely expected to cut interest rates when it meets in August. 24 of 25 economists surveyed by Bloomberg expect the bank to cut the cash rate to 1.50% — a fresh record low — while financial markets put the probability of 25 basis point rate cut at 71%.
To some, such a move risks fueling further substantial gains in Sydney and Melbourne property prices, exacerbating existing financial stability concerns by encouraging households to take on ever-increasing levels of housing debt.
However, that’s not the only potential problem that confronts the RBA when it comes to lowering interest rates further.
According to the National Australia Bank (NAB), not only will a rate cut add to financial stability concerns, it may also add to disinflationary pressures that already exist in the Australian economy, thwarting the RBA’s attempts to bring core inflation back to within its 2-3% target range.
Based on analysis from the NAB, a further rate cut risks adding to Australian housing supply — already growing at the fastest pace on record due to a surge in high density apartment construction — which in turn could place additional downside pressure on housing rents, already falling at the fastest pace on record, according to figures released by CoreLogic.
“The significant increase in apartment supply in train is likely to weigh on rental growth further, which is a large component of the CPI basket and means that the RBA will find it difficult to return inflation to its target band in the near term,” says the NAB.
“Interestingly, seeking to return inflation more quickly to the target band by repeatedly cutting interest rates could potentially be counter-productive as it could risk encouraging additional housing supply in a market where fears of oversupply are emerging.”
According to NAB economist Tapas Strickland, an economist at the NAB, “rents have been an important explanation of lower core inflation outcomes in Australia since the Global Financial Crisis” helping to “explain as much as half of the moderation in core inflation in recent years”.
The chart below, supplied by the NAB, shows the annual change in capital city rents going back to 1990.
Although there are many factors that have contributed to the slowdown in core inflation in recent years, the annual change in capital city rental rates, particularly in Sydney and to a lesser degree Melbourne, look eerily familiar to the Reserve Bank of Australia’s official cash rate. Steadily increasing in the years prior to the GFC, followed by a sharp pullback in 2008-2009, before lifting again in 2010 to 2011 before decelerating yet again in recent years.
According to the NAB, the rapid increase in new housing supply in Sydney, Melbourne and Brisbane is likely to add to the moderation in rental growth, hinting that an “important and large part of core inflation is likely to remain very low, and likely even moderate further”.
“Either way, given the significant new apartment supply in prospect over coming years, the RBA is likely to have to get used to, to some extent, subdued core inflation readings for some time,” it says.
NOW WATCH: Money & Markets videos
Business Insider Emails & Alerts
Site highlights each day to your inbox.