Amid the tumultuous economic climate in the US and Europe – not to mention the tumbling fortunes of our sharemarket – the Reserve Bank of Australia has followed market sentiment and cut the official cash rate by 25 basis points.
Experts Dianne Thomson, Kevin Davis, Jakob Madsen and Michael Thorpe explain the reasons behind the RBA’s decision and outline the challenges facing our economic policymakers.
Kevin Davis, Research Director of the Australian Centre for Financial Studies and a Professor of Finance at University of Melbourne
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Twenty-five basis points was the generally expected figure, but there was a lot of uncertainty, given the nature of the world economy. But having just cut the rate by 50 basis points the previous month, it was unlikely they were going to take another big plunge.
Part of the issue of course is that what the Reserve Bank does with the cash rate is a lot less important than a lot of people think, because ultimately no one borrows at the cash rate apart from the banks, when they lend account funds to each other. The cash rate does influence the overall structure and level of interest rates, but what’s much more relevant for economic activity is the lending rates the banks are charging or the deposit rates they’re charging.
As we’ve seen in the course of the past couple of years, there’s daylight between the cash rate and what the banks decide to do.
I’m of the view – and many others are too – that the banks make profits higher than required. It’s certainly the case that movements in the cost of funding are quite different to what happens in the cash rate. The borrowings by banks in international capital markets are influenced by a whole range of other things, including concerns about credit risks.
We’ve also got the situation where because of developments in those markets and the desire by the banks to get back to a more stable funding arrangement, there’s been a big increase in their demand for term deposits from domestic savers, which pushes up the interest rate they have to pay on those funds much more than the cash rate. It’s very hard to know what the banks will do. The way in which various interest rates are shifting around in international markets and the uncertainty in working out the overall cost of funds makes it next to impossible.
So the game now will be predicting how the banks react: will they pass 25 basis points on? You have to remember that when the Reserve Bank sets the cash rate, it takes into account its own expectations of what the banks might do based on its view of what’s happening to the banks’ funding. It’s all a bit of a circular game.
Jakob Madsen, Xiaokai Yang Professor of Business and Economics at Monash University
It was definitely an expected and prudent decision. Our economy is going quite well when compared to Europe, but clearly it seems that domestic growth can’t be expected to be too high. If we refer to the government’s expectations in the federal budget, we already knew that growth wasn’t going to be very high at all.
I am hopeful that there will be positive growth in the next six months, but given that the stockmarket has been falling quite a lot, and that the housing market has been in decline, it usually indicates that the economic growth will decrease. We can expect very low growth rates, probably close to zero — perhaps even negative growth. It’s impossible to predict.
But based on the stockmarket, the housing market, and what’s going on in Europe and the world economy by and large, I this is a negative sign for the Australian economy. I don’t think we should expect much growth. That’s why the RBA has decided to cut the cash rate — it is probably equally pessimistic about the prospect of future growth.
Associate Professor Michael Thorpe, Head of Department, DSchool of Economics and Finance, Curtin University
There’s a lot of uncertainty at the moment, particularly in Europe. That’s going to have an impact on China, and China is having its own concerns about the slowdown. The government there is starting to pump prime by putting more expenditure into infrastructure projects. They’re certainly concerned about the lack of impact, so there’s a push to get more private consumption driving economic growth. They’re reverting back to government spending on big projects: coal, ports, things like that.
But still, the global economic climate is pretty uncertain. In the US, if we look at recent data, there’s certainly not a lot of optimism there. Australia is certainly concerned about that, and so the RBA is being a bit more cautious by cutting the rate by 25 basis points. We would expect that they will continue to watch world events more closely and we should see some more cuts from the RBA in the future.
Dianne Thomson, Senior Lecturer in Finance at Deakin University:
I suspected they would cut interest rates and that, to be conservative, they would opt for a cut of 25 basis points. A cut of 50 basis points is quite dramatic and it risks sending the message that the economy is in worse shape than it really is. They didn’t want to paint that kind of picture. If they’d gone for a cut that big it would have surprised me.
By opting for a smaller cut, they’ve left the way open for another cut of 25 basis points next month or the month after, if that’s what they want to do. I think they’ve made the right move. The feeling is that most of the leading indicators suggest the economy is slowing — for example retail sales and new housing starts.
We won’t even know about unemployment and inflation figures for another month at the earliest. Looking at the international environment as well as our own leading indicators, you would think that the economy is starting to stall a little. It will be very interesting to see how the banks respond.
It seems that their game plan is not to pass on the full rate cut in their variable interest rates, so I suspect that will be the case. It really depends on interest rate margins, which are roughly at about the 2% mark at the moment.
They would want to maintain that margin — which is reasonable — so they don’t have a lot of fat to take out of that. Their big argument is that their funding costs have been rising, so is it getting more expensive to build domestic deposits at the moment? If not, then they should probably pass it on. But the historical evidence from the past six months is that they’re probably not going to. So if they don’t, it won’t be a surprise.
This article first appeared on The Conversation.