The Reserve Bank of Australia (RBA) began cutting interest rates in November 2011. Since then, the RBA has consistently argued that monetary policy was operating just as it usually does and that people should be patient in waiting for the full effects of the rate cuts to become apparent. But how long should we wait?
In our view, we are currently nearing the point at which the RBA rate cuts will have their maximum stimulatory effect. After this, the stimulatory impact will gradually fade. This is concerning as some recent indicators, such as the NAB business survey, suggest that activity is slowing rather than accelerating. This indicates that further rate cuts are needed to sustain the stimulus currently in place and guard against a material slowing in growth.
How large will these further effects be?
In the statement released after the RBA’s July 2013 Board meeting, the Bank argued that: “The easing in monetary policy over the past 18 months has supported interest-sensitive spending and asset values and further effects can be expected over time.” The minutes of the July Board meeting were just as clear: “The effects of lower interest rates were apparent across a range of indicators and, given the lags involved in the transmission of monetary policy, this process had further to run.”
The key question, however, is how large are these “further effects” and when can they “be expected” to materialise? Based on our monetary policy model, if the RBA cuts the cash rate to 2 per cent over the remainder of 2013 – and this was fully passed on to mortgage rates – policy wouldn’t become much more stimulatory, but the stimulatory impact would be sustained for a much longer period.
What about the level of interest rates? Do they matter?
One criticism about focusing too much on the change in interest rate is that it ignores the benefits gained from the low level of interest rates. The RBA Governor, in particular, has been adamant that it is the level of interest rates that matters most. A blithe response to that criticism would be that this simplistic approach seems to work, and so while it may not be theoretically correct, it is still useful.
In truth, we think that it is both the level of rates as well as the change that matters for growth. If we think about the impact of monetary policy on household cash flow, for example, then it is the change in rates that matters. If mortgage rates fall from 7 per cent to 5 per cent, then during that transition, interest payments fall and disposable income rises, enabling more household spending. If interest rates remain at 5 per cent thereafter (and there is no change in wage growth) then disposable income growth will decline back to the level of wages growth. Hence, that stimulatory impact will lessen even though the level of mortgage rates remains low.
On the other hand, if mortgage rates are very low while rental yields are high then demand for housing could increase sharply, pushing up house prices as well as the perceived return from owning property. Thus, a sustained low level of interest rates could result in an ongoing boost to housing demand, at least until rental yields declined to very low levels and housing affordability choked off the marginal buyer. In this example, it is the level of rates that is important.
If, however, it is both the level and change in rates that determines the size of the stimulus, then there will be a point at which the stimulus from past rate cuts peaks and then declines (even if it doesn’t disappear completely). Based on our analysis, the peak stimulatory effect will likely occur in the next three months.
Don’t expect any fireworks
When the RBA says that the “further effects” of lower interest rates can be expected to materialise over time, this is strictly correct. But the point at which the impact of past interest rate cuts reaches its peak is imminent. Furthermore, the incremental stimulatory impact is only modest compared to what the economy has experienced over the past 3 months. While the stimulatory impact should be reaching a peak, recent indicators on the economy suggest that growth is weakening. Hence, those analysts looking for a dramatic turnaround in growth momentum may well be disappointed.