Is this the end of the line on RBA rate cuts?

A gentle improvement in the economy could shift views on rate cuts in the months ahead.

The Reserve Bank maye keep rates on hold this year

The Reserve Bank is given the daunting tasks of keeping inflation within a fairly low range, delivering high employment and promoting financial stability. The bank’s main tool of trade in achieving these goals is setting the “cash rate” — the interest rate at which banks, including the RBA, borrow and lend short-dated funds with each other.

Changes in the cash rate affect the cost and availability of funds throughout the economy, and ­affect asset prices (particularly prices of shares, property and bonds) and on total spending on goods and services. The level at which the cash rate is set has markedly different effects on borrowers and lenders.

For these reasons, investors need to keep a close watch on what’s happened to the cash rate — and on market expectations for likely changes in the cash rate over the next year or two.

Suggestions that our cash rate — currently at a record low of 0.75 per cent — will be increased in the next 12 months are almost non-existent. Unemployment, and particularly underemployment, are high; for four years, inflation has been below the target range (of 2-3 per cent a year over the cycle); and most other central banks are also expected to maintain highly accommodative policies, to boost spending and give a (gentle) lift to their inflation rates.

Even the US, where measured unemployment is at a 50-year low and the economy has been steadily growing for 11 years, seems unlikely to raise its cash rate this year — due to stubbornly low inflation. But investors should note that US medium and long-dated US bonds are priced for extremely low inflation over the coming decade; a whiff of inflation could raise yields on US longer-dated bonds even if the Fed holds its cash rate steady.

There are three main possibilities for what could happen to the Australian cash rate over the next 12 months: one or two further reductions that would take it close to zero; or the RBA could set a negative cash rate (as the Euro­pean Central Bank has done); or our cash rate could be left unchanged. Of course, expectations in financial markets on which scenario is the most likely will at times swing widely, as fresh economic data is released or the RBA changes its commentary.

Scenario #1: The RBA makes one or two further cuts in the cash rate but does not introduce unorthodox monetary measures.

This is the expectation of investors and commentators who fear the coronavirus will seriously depress growth in China and the world economy, and/or who see Australia as struggling to maintain a growth momentum following the bushfires and drought.

The consequences would generally be unhappy for investors. Savers would get virtually no return on their holdings of cash or term deposits. With debt carrying near-negligible interest costs, some people would borrow too heavily, endangering financial stability. And share investors would be concerned the RBA had used all its armoury of conventional policies without lifting growth or average incomes.

Scenario #2: The cash rate is lowered and unorthodox policies are introduced.

In 2019, some commentators suggested the RBA would end up having to cut the cash rate and introduce the “unconventional” policies the eurozone has adopted, including quantitative easing (that is, targets for the volume of bonds it will buy from the public) and a negative cash rate. Support for this proposal has faded, but will be revived if the economic impacts of the coronavirus outbreak are drawn out and sizeable.

Investors would find that negative interest rates would make planning a comfortable retirement even more difficult than it’s been; and the heightened incentive to borrow would threaten financial stability.

Scenario #3: The RBA simply leaves the cash rate unchanged over the coming year.

Recently, the RBA has suggested the global and Australian economies are on a gentle turning point upwards; and a number of investors and commentators, including this columnist, have agreed. This view could become the dominate one in coming months as evidence emergences of a green shoot of recovery in the global economy, and as growth improves in Australia.

The impact would be (mildly) positive for sharemarkets, with low interest rates persisting and with expectations building up of improving business conditions. Interest rates on cash trusts and term deposits wouldn’t need to decline further.

Much will depend on how soon the coronavirus outbreak is contained. There are many uncertainties and risks — but also reasonable prospects that this flu virus will turn out to be a serious event rather than a lasting trend.

Around the world, monetary policies are likely to remain highly accommodative; the US economy hasn’t hit any major road blocks to its long-running — and moderately paced — cyclical upswing; China has eased its fiscal policies; and some, though limited, relief has been applied in the tariff wars.

Growth in Australian spending should also pick up in 2020. Last year’s three cuts in the cash rate and July’s reduction in income tax rates for middle income earners mean households have been saving more and reducing debt. The bank expects consumer spending to strengthen as households become more comfortable with their balance sheet positions.

Don Stammer is an adviser to Stanford Brown Financial Advisers. The views expressed
are his alone.

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