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Behind the curtain: what drives RBA decision making?

November 7, 2019

 

The RBA’s decision to hold on interest rates gives us time to take a deeper look at what is going on. After all, there could be further cuts. What drives the decision making? What could send rates lower?

 

To cut or not

 

On the first Tuesday of each month, except January, the RBA board meets to decide if the cash rate – the market interest rate for overnight loans between financial institutions – should increase, decrease or stay the same.

 

It’s an important call because the cash rate has sway over other interest rates including lending rates for consumers and businesses. And in turn, these rates can influence economic activity, employment and inflation.

 

There is a range of factors at play every time the RBA makes its decision. To make their call, the Reserve’s board considers national indicators including inflation, unemployment levels and wage growth, household consumption and debt, and investment in business. They also explore international factors like terms of trade, exchange rates and overall global economic conditions.

 

So, if economic conditions are weak, the RBA can lower rates in an attempt to stimulate growth, employment and consumer confidence. Similarly, increasing rates can be a way to cool an overheating property market, by influencing the cost of borrowing.

 

Why lower the rate?

 

The RBA aims to keep unemployment below 4.5%, and inflation between 2% and 3%. Adjusting the cash rate is a broad-brush incentive designed to keep the economy within these numbers.

 

Economic growth in Australia is currently at 1.4%, which is positive but weak – and the lowest level since the Global Financial Crisis. The International Monetary Fund has predicted Australia’s economy will grow 2.3 per cent in 2020, down from a predicted 2.7 per cent in their April forecasts.

 

International events can also cause conditions where rate cuts may be needed – just look at how the US-China trade war and uncertainty around Brexit have led to lowered global and local economic confidence.

 

When announcing October’s cut, RBA governor Philip Lowe explained that “while the outlook for the global economy remains reasonable, the risks are tilted to the downside”. If Australia can’t depend on international investment to drive our economy, the RBA can use domestic rate cuts to stimulate growth.

 

“International events can also cause conditions where rate cuts may be needed – just look at how the US-China trade war and uncertainty around Brexit have led to lowered global and local economic confidence.”

 

Will rates continue to fall?

 

The RBA has given some indication that rates will stay low for the foreseeable future, and possibly drop further. RBA governor Lowe recently said it would be reasonable to expect that an extended period of low-interest rates will be required, adding that the RBA is prepared to ease monetary policy further.

 

He has since wound this back a little, telling the IMF in Washington that more cuts might be necessary but that it’s wrong to assume this is a certainty.

There’s also a chance that rates could be lowered into negative territory – something that’s never occurred in Australia before. We’ve seen this happen in Europe, where the Central Bank rate is -0.5%, and in Japan where rates are at -0.1%. But Lowe believes this will be unlikely in Australia.

 

Which lever to pull?

 

Traditionally, if wage growth, inflation and housing prices rise, then interest rates will also rise. And there are measures outside of monetary policy that could stimulate economic improvement too.

 

The IMF’s October World Economic Outlook report suggests that “monetary policy cannot be the only game in town and should be coupled with fiscal support where fiscal space is available and where policy is not already too expansionary”.

 

In other words, the larger issue is getting the touch right on the economic levers. Interest rate cuts alone may not always solve economic problems – and other measures may be required to stimulate the economy.

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