Understand what’s driving the interest rate merry-go-round

After months of forecasting more interest rate cuts, the mood of economists and the Reserve Bank appears to have changed – causing confusion for borrowers. Here’s what you should know.

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How quickly the interest rate merry-go-round can change.

One minute, borrowers are happily riding it, listening to carnival music while waiting for their inevitable interest rate cut.

Next minute, the shiny white merry-go-round horse bucks them of with an evil whinny and they’re sitting in the dirt, wondering where their mortgage rate cut went.

That’s the confusing ride confronting home buyers and owners since the start of the year, when a Reserve Bank of Australia interest rate cut seemed almost certain for February.

But throw in a few positive releases of economic data and voila! No rate cut in February.

Today, financial markets say there’s less than a 10 per cent chance of a rate cut in March – despite the negative economic impacts of fires, floods and the coronavirus.

Beware of evil horses on the interest rate merry-go-round

Amid this confusion, maybe it’s a good time to have a look at what actually drives the Reserve Bank’s decision making when it meets to discuss rate moves on the first Tuesday of every month.

INFLATION

Consumer Price Index inflation is the main economic factor affecting RBA rate decisions. For almost 30 years the RBA has had a target of 2-3 per cent inflation, which it believes will “encourage strong and sustainable growth in the economy”.

The RBA’s official interest rate, called the cash rate, is its main tool to keep interest rates in that target band. If it wants to put the brakes on rising inflation and a fast-heating economy it will raise rates to slow down spending, and if it wants people to spend more and boost the economy it cuts the cash rate.

The tool was effective for many years but now appears broken. Despite continuous cuts to record low interest rates, inflation has stayed stubbornly below 2 per cent. It’s a similar story all over the world, and RBA governor Philip Lowe isn’t confident that more cuts will increase inflation.

JOBS

Dr Lowe injected employment into the rates debate at lunch in Adelaide last year when he said there was “spare capacity in our labour market” and rate cuts could help lower the unemployment rate.

Jobs data was a key factor in the RBA keeping rates on hold this month. Better-than-expected December unemployment figures released in late January caused an about-face by economists who were forecasting a February cut.

Dr Lowe said unemployment was expected to remain around its current level of 5.1 per cent until at least next year.

OTHER ECONOMIC FACTORS

Natural disasters and the coronavirus have been surprises that are likely to dent the Aussie economy this year, but the cash rate of 0.75 per cent is already almost as low as it can go.

The RBA’s rate cut floor is 0.25 per cent because it doesn’t want banks charging savers to hold their money. If rates do go to 0.25 per cent, its next steps are “unconventional measures” such as printing money.

The Aussie dollar has sunk to its lowest level in a decade and is also helping economic activity – a fact noted in this month’s RBA rates announcement.

This will year be an interesting ride for rates. If you get thrown off the merry-go-round horse, just hop back on.

@keanemoney

Originally published as Understand what’s driving the interest rate merry-go-round