On the second Tuesday of every month, the Reserve Bank of Australia (RBA) makes its cash rate decision, a decision that is integral to the modern economic machine. The cash rate is the interest rate at which banks can borrow from other banks and the central bank itself on an overnight basis, forming the foundation of a country’s monetary policy. This single lever controlled by the RBA in Australia has an impact that reverberates throughout the economy, affecting everything from the strength of the Australian Dollar to the spending patterns of the consumer.
As the interest rate paid on unsecured loans in the overnight money market, the RBA cash rate is the lowest rate at which banks can borrow from each other and serves as the benchmark rate of the economy. In deciding the interest rate to charge consumers for a specific product, the RBA cash rate forms a part of their operational expenses. Along with the cash rate, the bank also considers the risk of the customer to default, necessary margins for shareholder returns and the rates offered by competition. In this vein, if the cash rate is lowered, the bank may lower the interest rate charged on loans and influence consumers to borrow more. By lowering the cash rate, the RBA intends to stimulate the economy by boosting investment and consumer spending.
On the other hand, raising the cash rate can slow down the economy. This seems counterintuitive; after all, why would a country want slower growth? The answer lies in the inflation rate, the rate at which the cost of living is changing over time. When the economy is moving too fast, there is a risk that goods and services rise in price too quickly leading to increases in the inflation rate. If out of control, people’s life savings could be lost in a single night. Another way the cash rate slows down the economy is its ability to induce consumers to save. With a higher cash rate, banks are able to offer higher interest rates on deposits. Overall, the cash rate operates under the assumption that it effects the spending habits of consumers which projects throughout the economy and that banks are willing to pass on lower rates to consumers.
Turning up the heat
Following the rate decision on the 7th of May, the RBA has held the cash rate at a record low of 1.5%. It has been held in this position since September 2016, a record 30 months of stagnation. Perhaps coincidentally, September 2016 was also the month Philip Lowe, the current RBA Governor, started his term. However, in recent months there has been added pressure from economic conditions for the RBA to reduce the cash rate.
One of the explicit goals of the RBA is to ensure the value of the Australian currency by maintaining the inflation rate at an average of 2 – 3% over the ‘medium term.’ Yet, it seems the RBA has not been achieving this goal. With annual inflation rates consistently below the target region from 2015-2019, there has been a steady build-up of pressure for the RBA to cut rates.
Lowe has defended the RBA’s position by referring to other economic metrics. The unemployment rate measures the percentage of the total labour force that is unemployed but actively seeking employment. Despite this definition, good economic health is not as simple as having the idealistic 0.0%. If the unemployment rate is zero, companies compete fiercely for workers, which causes rapid wage growth and a subsequent explosion in inflation. Therefore, the notion of healthy ‘full employment’ has traditionally been 5.0%. This rate is often referred to as the Non-Accelerating Inflation Rate of Unemployment or NAIRU, as it allows companies to hire workers sustainably, without pressure to offer exorbitant wages to induce scarce available labour.
In November 2018, the Australian unemployment rate reached a low of 5.0%1, yet wages did not grow as expected. In a speech, Lowe commented “I suspect nationally, we could sit around 4.5% [unemployment] without seeing wage growth pick up too much … our underlying strategy is to have labour markets tighten up, to get wages to pick up.” In this vein, Australia’s NAIRU level could fall to 4.5%.
Another factor adding pressure on the RBA to cut the cash rate is the slowing housing market. Fitch Ratings forecasts Australian housing prices to fall another 5% this year on top of the 6.2% drop already from the peak2. This makes the Australian housing market the world’s worst performer out of 24 examined nations. With these prices experiencing the sharpest drops since the GFC due to a downturn in demand, it is important for the RBA to stimulate economic activity and maintain the wealth of individuals who have invested in property.
On April 24th, 2019, the Australian Bureau of Statistics released the inflation rate figures for March (Quarter 1) 2019. Among this dataset included the alarming figures of 1.3% annual inflation since March 2018, well below the 2-3% target region, and a whopping 0.0% inflation in the first quarter of 20193. These two numbers have led to the cash rate decision on May 7th being labelled the ‘most exciting in two and half years,’ with analysts and economists forming almost a 50-50 split in opinion between holding or cutting the rate to 1.25%.
At 2:30pm, with the releases of the RBA’s decision to hold the rate at 1.5%, the Australian Dollar rose 0.8% to US70.45c while the ASX200 slumped 0.62%. Lowe justified this decision by explaining that “spare capacity in the labour market trumped any concern of slowing growth”4. With this, Lowe has made apparent that he has prioritised healthy unemployment figures leading to wage growth over the inflation target of 2-3%.
With New Zealand’s central bank cutting their cash rate on the 10th of May5, it seems that a change in the RBA’s cash rate is due. Growing global uncertainty with forecasts of downturns and an increase in market risk has introduced an ominous prospect for the RBA. This is compounded by the weakening effect of monetary policy in the world’s economies as a whole. After the past two years of relative banality, it seems that the RBA cash rate is finally on the move.
The CAINZ Digest is published by CAINZ, a student society affiliated with the Faculty of Business at the University of Melbourne. Opinions published are not necessarily those of the publishers, printers or editors. CAINZ, its Partners and the University of Melbourne do not accept any responsibility for the accuracy of information contained in the publication.
Matthew is a third-year economics and finance student with experience working in sustainability consulting and energy. He enjoys writing about technology, politics and macroeconomics.
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Laukik is a Master of Finance student and a CFA Level 3 candidate. An interest in global economic developments, technological advancements and investment strategies has driven him to pursue a career in asset management. When his head isn’t hidden behind a laptop, he is in the gym doing burpees and mountain climbers!
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