Australian interest rates have fallen a lot over the past decade.
The Reserve Bank of Australia’s cash rate currently sits at 1.5%, well below the 7.25% level just before the onset of the global financial crisis in late 2008.
In an attempt to offset the effects of that crisis, and more recently, help the Australian economy through its once in a multi-generational economic transition away from the mining infrastructure boom, the RBA has taken interest rates to levels never seen before.
Monetary stimulus has been applied, and, so far, appears to have done its job. While there have been potholes along the way, including in the 2016 September quarter, the economy has continued to grow, powered by lower borrowing costs, a weaker Australian dollar and, as a consequence of both, a rebound in Australia’s non-mining sectors.
However, even with the cash rate currently sitting at a record low, it is probably not as stimulatory on the Australian economy as it would have been in the past. And, even if rates increase in the next 12 months, as some are starting to forecast, it’s unlikely to herald the return of sharp, and steep, monetary policy tightening cycle from the RBA.
That’s the view of Gareth Aird, senior economist at the Commonwealth Bank, who suggests there’s a simple reason why Australian interest rates are unlikely to return to the levels seen before the global financial crisis anytime soon.
Australia’s “neutral” cash rate — the level where interest rates have a neutral impact on the economy — is now significantly lower than where it sat in the past, he says.
“A range of estimates and theoretical arguments suggest that the neutral cash rate has moved to a record low,” he said in a research note on Monday. “Our qualitative and quantitative analysis points to a neutral range of 2.5%-3.5% meaning a point estimate of 3%.”
So the level where the cash rate will neither stimulate or slow the economy is now just 150 basis points higher than the current level, according to Aird, leaving it well below the 5%-plus levels the RBA deemed to be neutral in the past.
The reason for this decline in the neutral cash rate level is based on several factors, says Aird, noting that slowing productivity growth, an increase in household indebtedness, higher lending spreads to the cash rate from lenders, contractionary fiscal policy and renewed strength in the Australian dollar, particularly in trade-weighted terms, have acted in unison to lower the neutral level in recent years.
So why should you care that the “new” neutral RBA cash rate is now lower than what it once was?
Well, it has ramifications for future interest rate settings from the RBA, says Aird.
“The analysis suggests that the RBA is faced with a relatively easy task if it needs to put the brakes on the economy at some point further down the road,” he says, noting that “it wouldn’t take a lot of tightening in policy to restore monetary policy to a neutral setting”.
With the neutral cash rate now significantly lower than in the past, any rate hikes will take monetary settings quickly back towards a level where they would no longer help to stimulate the economy.
Just think about the impact that a 25 basis point rate hike would have on a household servicing a $500,000 mortgage, compared to one half that size.
As a result of increased household indebtedness in recent years, the impact on the hip pocket of households is now significantly larger than what it was in the past.
That explains why the cash rate is unlikely to return to the levels seen before the GFC anytime soon.
But as Aird points out, a lower neutral cash rate also makes it more difficult for the RBA to help stimulate the economy through additional rate cuts.
The fall since the GFC has already brought forward so much demand from the future, encouraging households to leverage up, in many instances to invest in property.
While a lower cash rate will help reduce debt servicing costs, presuming it is passed on by lenders, with debt levels already so high, it’s arguable just how successful further reductions would be in helping to pull forward demand among households.
“It becomes harder for the RBA to stimulate the economy as the neutral rate falls and we approach the lower bound,” says Aird.
It’s not exactly a desirable position for the RBA. If it tightens policy, even slightly, it risks slowing the economy sharply, and if it cuts further, it may not do much to boost growth.
With the RBA in a policy bind, Aird says fiscal policy must now play a more prominent role as a result.
“The need for meaningful fiscal policy reform grows as a result,” he says.
“We don’t see the RBA tightening over 2017. And in our view the risks like with further easing.”
As such, Aird says that “calls for fiscal policy reform in addition to higher levels of public investment will continue”.