Macquarie economist Justin Fabo is one of many who have recast their forecasts for monetary policy and now believes there will be two cuts this year, with the first potentially coming as soon as May.
While the domestic and global economies have weakened, he doesn’t believe they have “fallen in a hole”. Rather, he thinks easier policy now is the “path of least regret” for the RBA, given the weakening economy, falling house prices, and a bigger worry that inflation will get too low rather than too high.
“We don’t see downside risks from cutting,” Fabo says.
But with rates so low already (and negative after inflation), with property prices falling and household indebtedness high, would rate cuts make any difference at this point?
“That’s the whole question,” Gor says. “If you cut rates and it doesn’t have an impact, what do you do?Cut rates lower? Think about QE[quantitative easing]?”
Monetary policy, by changing the interest rates for households and businesses, affects economic activity through a number of channels.
Save less, borrow more
First is the “saving and investment” channel. As rates fall, the incentive for business and households is to save less now and borrow and spend more.
So you and I might buy new televisions or washing machines, cars, or even a new house. In this way, lower rates typically flow through to higher household spending and housing investment.
In recent decades, changes in the cash rate have been highly correlated with housing lending and credit growth. But we are at the tail-end of a massive building boom and a historic run-up in house prices and indebtedness and it’s hard to argue that monetary policy can squeeze much extra economic stimulus from this channel.
UBS analysts go further. They reckon the macroprudential policies put in place in late 2014, which require lenders to use a minimum rate of 7 per cent when assessing a borrower’s capacity to repay a loan, will neuter the impact of a lower rate.
“Any further reductions in the RBA cash rate and reductions to bank mortgage borrowing rates will not lead to an increase in borrowing capacity given rates are already below the floor rate,” they write.
But Macquarie’s Justin Fabo is not convinced.
Even if the mandated minimum serviceability rate is unchanged, a drop in mortgage rates makes loans cheaper for those who can afford it.
Beating the hurdle
“Put yourself in someone’s shoes sitting on the sidelines, a cut in rates can still bring you in” to the housing market, Fabo says. “The fact that the bank will judge you at 7 per cent won’t matter if you know you can beat that hurdle.”
What’s more, existing mortgage holders will presumably also receive some relief in the form of falling interest costs, which means they have more to spend on other things – also a potential tonic for households and spending.
The RBA calls this “the cash flow channel”, and it should remain effective – perhaps even more so as we are carrying more debt than ever, so will feel the relief more.
It’s not great for lenders, though. Further cuts in the official rate would be “painful” for the banks, the UBS analysts note, even if they only pass on a portion of the fall in rates.
Then there is the effects from changing asset prices and themuch-discussed “wealth effect”, which holds we tend to spend more if our measured net worth climbs (and vice versa).
If lower rates aren’t going to trigger a sharp lift in credit growth, then nor should we be expecting house prices to suddenly start climbing. But it might slow or even arrest the declines, so at the margin prove useful. (Not that RBA officials would ever say they are targeting house prices.)
Lower rates would also hit the currency, a key channel for the transmission of monetary policy through to the economy. A cheaper dollar makes our goods and services cheaper to the rest of the world, particularly for fast-growing segments such as tourism and education.
Yet a lower currency won’t be “the elixir that brings the economy back to the 3 per cent growth path that the RBA is projecting”, NAB head of currency strategy Ray Attrill warns.
The two-cent fall in the Aussie in recent weeks (it now sits a touch above US70¢) suggests expectations of rate cuts are likely already largely priced in, Attrill says.
And in any case, his analysis suggests that a 25 basis-point cut historically leads to only half a US cent fall in our dollar, with risk sentiment and commodity prices also playing their roles.
All in all, there probably is an argument that monetary policy is a bit less effective now than previously. But the RBA is not likely to view that as a reason to do less, or nothing at all, but as a reason to do more.