Governor of the RBA, Phillip Lowe has announced that the current cash rate will remain unchanged for the month of September. In this article, we will explore why this decision has been made, especially when the implications associated with an increase or decrease in the cash rate at its current rate are considered.
1. Cash rate remains the same at a historical low of 0.10%
It’s fair to say that this decision was not surprising. The cash rate has not moved for 10 months, and furthermore, has not increased in over a decade. However, it is easier to understand the decision when you take a look at the current state of the Australian economy, where both growth levels and employment figures are expected to fall substantially during the September quarter following the nationwide lockdowns as well as the general lack of consumer confidence deterring an increase in the cash rate. When one considers the latest inflation rate at 3.8% (the highest in a decade), it would be reasonable to assume that the RBA would also factor this into their overall decision.
However, it is important to note that this rate of inflation was the headline rate inflation (taking into consideration the price movements of the vast majority of goods and services), while the underlying rate of inflation (which does not consider volatile price movements) was only at 1.6%, still below the goldilocks rate of 2-3% as targeted by the RBA.
It is worth mentioning that this substantial increase in headline inflation was partly due to soaring petrol prices across the globe, though the impacts on the Australian economy have been partly cushioned by the lockdowns (with a significant number of us homebound). Thus, with numerous forecasts indicating a contraction of growth during the September quarter, and no imminent threat of the ‘inflation dragon’, the RBA has decided not to increase the current cash rate.
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2. What would happen if the RBA decided to decrease the cash rate?
The cash rate, being a historic low, is edging closer and closer to 0% and even negative. However, what would this entail? It is important to remember that although the cash rate is the interest rate used in the cash market (where the banks borrow and lend money to each other), changes to the cash rate are normally passed on to consumers in some shape or form.
However, this is where concepts such as the liquidity trap take the spotlight, as it is a phenomenon where the cash rate has decreased to a point, where the changes are incremental to the point where consumer behaviour is no longer impacted despite the change. Such factors are exacerbated by periods such as COVID-19, where consumer confidence has already been greatly impacted.
It should also be noted that the RBA has been vocal in reassuring that the cash rate will not go below 0.10%, with Phillip Lowe highlighting that it was “extremely unlikely”. This is mainly because lowering the cash rate any further would not produce good economic outcomes in the long term.
Globally, the latter is considered to be quite unconventional, however, it is present in economies such as Japan and Denmark. It is considered to be unconventional because a negative cash rate entails that interest is credited towards borrowers rather than lenders, disincentivising savings, and encouraging both consumption and investment, and ultimately aggregate demand.
However, it should be noted that the negative cash rate generally impacts banks as opposed to everyday consumers (as banks decide whether or not to pass these rates on to consumers) and the negative cash rate mainly impacts reserves held within the central bank (essentially where commercial banks deposit and withdraw their money from, such as the RBA).
It should be noted that this can prompt commercial banks to divert their reserves from the central bank to other forms of equity, most notably government bonds which are considered to be less risky in terms of returns. However, over time, this can cause volatility in the price of assets, which can have further impacts on consumer confidence, ultimately highlighting the implications associated with negative interest rates, especially in terms of long-term growth.
For these reasons, Phillip Lowe has indicated that the Reserve Bank’s focus will be less on the cash rate (until they believe they can increase it) and focus on tools such as quantitative easing.
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