During the global financial crisis (GFC) central banks across the world cut interest rates and resorted to unconventional policies to stimulate demand and generate economic growth.
Ten years later, the Reserve Bank of Australia (RBA) is following a similar playbook. Concerned about the outlook for growth and inflation, the RBA has cut interest rates to a record low level and is investigating the possible implementation of quantitative easing (QE).
The shift in policy stance has been remarkable. Twelve months ago, the Reserve Bank Board in its monetary policy minutes told Australians that “members continued to agree that the next move in the cash rate was more likely to be an increase than a decrease, but that there was no strong case for a near-term adjustment in monetary policy”.
Little did they, or the market, expect that the RBA cash rate would be cut three times in 2019. In a case of actions speak louder than words, Australian consumer confidence has fallen to a four-year low, and Australians are googling the words ‘Australia recession’ at a rate not seen since the GFC.
Why is the RBA cutting interest rates? To answer this question, it is useful to understand the objectives of Australian monetary policy. The Reserve Bank Act 1959 set out the objectives of:
- The stability of the currency of Australia;
- The maintenance of full employment in Australia; and
- The economic prosperity and welfare of the people of Australia.
Since the early 1990s, these objectives have found practical expression in a target for consumer price inflation of 2-3% per annum. In 1992, the then Governor of the RBA – Bernie Fraser – signalled the desirability of 2-3% inflation. In 1996, the new Governor of the RBA – Ian Macfarlane – and former Treasurer Peter Costello formalised the 2-3% inflation target in the ‘Statement on the Conduct of Monetary Policy’.
The statement which is used to outline the conduct of the central bank in implementing monetary policy was renewed by Treasurer Josh Frydenberg and Governor Philip Lowe.
Put simply, the inflation target is the centrepiece of Australia’s monetary policy framework. Currently the RBA is worried about meeting the inflation target and is hoping the lower interest rates will result in higher inflation over the medium term. Australia’s inflation rate has been below 2% for most of the past 5 years, and on reflection the RBA would likely privately acknowledge the interest rates were kept too high, for too long.
In 2020, the RBA will likely continue to reduce interest rates in the absence of a meaningful pick-up in inflation. As monetary policy inches closer to zero, the RBA will become more willing to consider quantitative easing to assist in meeting the inflation target.
Low inflation is not only a feature of the Australian economy: central banks across the world are typically experiencing inflation below their targets, and they seem powerless to correct the problem.
RECORD LOW INTEREST RATES
Interest rates in the UK, Europe, Sweden, Switzerland and Japan have been at or close to record lows for over a decade now and continue to grapple with low inflation. In Denmark, borrowers can qualify for mortgages with a negative interest rate, meaning the bank is paying people to borrow money.
The US has tried – and failed – to raise interest rates and has cut interest rates three times in 2019 in response to weakening economic growth. The question is whether the RBA is willing to follow the same path as its global peers.
Within the finance and economic community, there is some acknowledgement that monetary policy has reached its limits. For a long time, cutting interest rates has been the only game in town, with governments either unwilling or unable to expand their budgets fiscally.
There are now calls for a rethink of how central banks approach the goals of monetary policy, with unconventional approaches increasingly discussed amongst monetary policy practitioners and academic economists. It was not too long ago that quantitative easing was also perceived as unconventional.
For the average Australian, low interest rates pose both costs and benefits. Borrowers benefit, while savers face lower returns. Asset prices – like shares and property – tend to appreciate as investors seek the higher returns that they once enjoyed from defensive assets, exacerbating income inequality within a society.
Some have also suggested that ultra-low monetary policy has seen shifts to both the right and left of the political spectrum, leading to a shift in the political landscape. The RBA has acknowledged the distributional effects of low interest rates but believes that monetary policy is not well placed to address these societal issues.
As the Australian economy is driven by consumption and household spending, it is particularly important that the RBA tries to assess these costs and benefits. Perhaps the most important consideration regards the assumed positive relationship between the interest rate and the desired level of saving.
While it is conventional wisdom that lower interest rates will stimulate consumption, it is not always clear that this is the case in practice. There is a point where the rate of return of interest becomes so low that the last resort is to save more in the first place, leading to lower spending on consumption.
For example, suppose that savers have a predetermined amount of savings that they wish to accumulate over time. A lower interest rate, or lower returns from their investments, implies a slower rate of accumulation. Because the return on cash is zero, savers can no longer rely upon the “eighth wonder of the world” – compound interest – to boost their savings over time.
If Australians are saving more, rather than spending, then lower interest rates will likely lower household spending rather than raise it. Economists have defined the interest rate at which accommodative monetary policy for an economy reverses and starts to become contractionary as the ‘reversal rate’. This poses the question whether lower rates would do more harm than good for Australia.
There is a question whether the Australian economy requires further stimulus. Three interest rate cuts in 2019 now has Australians questioning the economic outlook, with households and businesses wondering whether the RBA has identified issues they themselves are not seeing.
As a result, Australians are becoming increasingly cautious as indicated by weak retail sales data and anecdotal evidence that households are choosing to pay of their mortgages at a faster pace rather than go out and spend. Monetary policy operates with a 12 to 18 month lag, and it’s likely the Australian economy will respond positively to the monetary policy stimulus seen in 2019.
However, there is a chance that the RBA, in pursuit of its inflation objective, may mistakenly cut interest rates again and implement a quantitative easing package in 2020.
Ultra-easy monetary policy creates mis-investments in the economy, threatens the health of the financial system, encourages governments to refrain from making structural reforms, and redistributes wealth in a highly regressive fashion.
Once on the drug of ultra-monetary policy, it becomes difficult for the economy and financial markets to wean itself of it, as evidenced by the experience of other central banks that have experimented with QE.
The Australian economy requires supply-side reforms, ideally combined with fiscal policies, that will help to make the economy more competitive and productive. This can be done by improving the functioning of markets, upgrading educational systems, building critical infrastructure and unleashing entrepreneurship and innovation.
Such measures will increase the potential for future growth. If this is understood – and believed – by the public, it could also increase confidence here and now, boosting spending and growth. This should be the approach to supporting the Australian economy as we enter a new decade, not the dangerous cocktail of low interest rates and quantitative easing.
Anthony Doyle is the cross asset investment specialist at Fidelity International.