The Reserve Bank has cut the official interest rate to a record low of 1 per cent. Tuesday’s 25 basis point cut to the cash rate follows a 25 basis point cut in June.
The key reason the RBA is cutting interest rates is to aim for a lower unemployment rate than previously targeted. Lower rates are needed to stimulate the economy, create more jobs, and increase inflation.
The RBA stated that the “decision to lower the cash rate will help make further inroads into the spare capacity in the economy. It will assist with faster progress in reducing unemployment and achieve more assured progress towards the inflation target”.
RBA Governor Philip Lowe will expand on the decision to cut the cash rate at a speech in Darwin on Tuesday night. Dr Lowe is likely to indicate there are more cuts to come later in the year.
Hitting a new unemployment target
The RBA made it clear that further interest rate cuts, in addition to Tuesday’s cut, are very likely.
The RBA stated on Tuesday that it will “continue to monitor developments in the labour market closely and adjust monetary policy if needed to support sustainable growth in the economy and the achievement of the inflation target”.
On the Monday before the RBA’s meeting, the financial markets predicted that the cash rate would fall to 0.75 per cent by February 2020, with the possibility of it going even lower by mid-2020.
There is one key reason the RBA will continue to cut interest rates. The central bank believes the unemployment rate needs to be below 4.5 per cent to push inflation from the current rate of 1.3 per cent up into its 2 to 3 per cent target range. Typically, lower unemployment contributes to higher inflation. The RBA previously thought that an unemployment rate of about 5 per cent was low enough for inflation to reach the 2 to 3 per cent target.
With the unemployment rate currently at 5.1 per cent, lower interest rates are needed to give the economy a boost and push the unemployment rate below 4.5 per cent. So the cash rate is likely to end up at 0.75 per cent or even 0.5 per cent within the next year.
Fiscal stimulus might be needed to boost the economy
The RBA has pushed the government to deploy fiscal stimulus, either in the form of increased spending or tax cuts, to provide a boost to the economy.
Dr Lowe recently stated that “we should also be looking at other ways to get closer to full employment. One option is fiscal policy, including through spending on infrastructure”.
Typically, the short-term fine-tuning of the economy is left to the RBA, with fiscal stimulus only used in times of crisis. But with interest rates approaching zero, the lowest point they can reach, fiscal stimulus may be needed to give a short-term boost to the economy.
But there are drawbacks to using fiscal stimulus to boost economic growth.
First, it is difficult for the government to inject money into the economy immediately, except in the form of tax rebates or cash handouts. The proposed “stage one” tax rebate will provide a small, but immediate, boost to household incomes if fully implemented.
Spending on infrastructure – even for planned projects – however, can take months or years to begin.
Second, there is the likelihood that money spent on infrastructure will be spent badly. Money is more likely to be allocated to projects in marginal seats, rather than on the most-needed projects.
But even so, in times of crisis, some waste may be justified to avoid the dire consequences of a recession, particularly a rise in unemployment which can scar a generation of workers.
Despite the arguments for fiscal stimulus, the government has reaffirmed its commitment to a budget surplus in 2019-20. But if the economy continues to slow and unemployment doesn’t fall the government should be open to changing its position.
Another alternative to fiscal stimulus is for the RBA to adopt unconventional monetary policies, such as by buying government bonds or other financial assets, to reduce longer-term interest rates. These strategies have been used overseas when interest rates have approached zero and would be an effective way for the RBA to boost the economy when the cash rate cannot be lowered any further.
Stabilising property prices could help the economy
We forecast that property price falls seen in most capital cities are expected to end later this year, with lower interest rates a key reason for the predicted turnaround.
The RBA stated that “conditions in most housing markets remain soft, although there are some tentative signs that prices are now stabilising in Sydney and Melbourne”.
A modest turnaround in property prices should help the broader economy. Rising prices will help boost the construction sector, which is facing a downturn in the next couple of years. The end of price declines will also give a boost to very weak property sales, which will help those closely linked to the property sector, but also struggling retailers and tradespeople.