Tuesday, February 03, 2015

Why I expect the Reserve Bank to cut interest rates on Tuesday

The Reserve Bank is set to cut interest rates on Tuesday because it’s the only thing it can do.

The Australian economy has the potential to grow at more than 3 per cent per annum. Until around two years ago it was. The latest readings have it growing at an annualised pace of just 1.6 per cent - far less than we have become used to and far less than would be needed to make a dent in unemployment.

The Reserve Bank is required by its Act to contribute to the maintenance of full employment and the economic prosperity and welfare of the people of Australia.

The only tool it has to do that is monetary and banking policy which means that, short of easing the rules to allow banks to lend more recklessly, the only means it has of edging Australia back towards full employment and economic prosperity is to cut interest rates.

The only constraint in its Act is the requirement that it contribute to the stability of the currency of Australia, which is taken to mean contributing to stable prices. Its agreement with the government commits it to strive to keep the rate of inflation between 2 and 3 per cent.

That constraint currently isn’t a constraint. The collapse in the oil price has pushed the inflation rate down to 1.7 per cent. Importantly the Bank believes that as the lower oil price feeds through into the price of everything we buy it’ll continue to bear down on inflation. The Bank can cut rates without the risk of breaching its inflation target.

So why wouldn't it cut, and why wouldn’t it do it tomorrow? One argument is that it waits long enough something else will boost the economy. But what? Consumer and business confidence have been low ever since the budget. Abbott has neither announced anything that would lift confidence nor has been replaced (which actually might lift confidence). Wage growth is the slowest in two decades; unemployment is higher than it has been in 12 years. Consumers are unlikely to get out their wallets and businesses are unlikely to expand without help.

Might the lower oil price provide that help? It is possible that it might. But it’s hardly enough reason to wait. The economy needs more of a boost than cheaper petrol is likely to give it, and the government is showing no sign of using budget measures to do it itself.

Cutting rates brings a risk. The risk is that consumers will use the extra buying power to bid up house prices rather than consume, and that businesses will pocket the lower borrowing costs rather than expand.

But what else can the the Reserve Bank board do? Interest rates are the tool it has been given. Sometimes you’ve got to use what you’ve got.

In The Age and Sydney Morning Herald

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