Reserve Bank cuts interest rates to historic

low of 0.75% to boost weak economy

This article is more than 2 months old
RBA’s third reduction in the cash rate in five months an attempt to
increase employment and lift stubbornly low inflation

• RBA’s rate decision – as it happened

Paul Karp

@Paul_Karp
Tue 1 Oct 2019 06.59 BSTLast modified on Tue 29 Oct 2019 21.14 GMT

The Reserve Bank of Australia cut its benchmark interest rate by a quarter of a percentage
point to a new record low of 0.75% on Tuesday. The RBA had been hinting at the move for
months. Photograph: Rick Rycroft/AP

Australia’s central bank has cut the official cash rate by 0.25% to a new record low of
0.75%.

The long-expected move follows months of signals from governor Philip Lowe that the
Reserve Bank was prepared to push rates lower to increase employment and lift
stubbornly low inflation back into the 2-3% target band.

The RBA’s cut marked the third reduction in the cash rate in five months.

In a statement, Lowe explained that although the “outlook for the global economy
remains reasonable, the risks are tilted to the downside”, with the US–China trade
dispute affecting global trade and businesses scaling back their investment.

Lowe said it was “reasonable to expect that an extended period of low interest rates will
be required”, suggesting the RBA is “prepared to ease monetary policy further”.

Australia’s economy grew by 1.4% in the year to June – the lowest recorded annual rate
since 2009 – which Lowe noted was “weaker than expected”.
With the unemployment rate rising from 5.0% at the start of the year to 5.3% in August
and an inflation rate of 1.6%, experts expect rates to fall at least as low as 0.5% to
further stimulate the economy after two successive cuts in June and July.

Lowe said the economy had reached a “gentle turning point”, with growth a little higher
over the first half of this year than over the second half of 2018.

“The low level of interest rates, recent tax cuts, ongoing spending on infrastructure,
signs of stabilisation in some established housing markets and a brighter outlook for
the resources sector should all support growth,” he said.

But Lowe warned that “employment growth is likely to slow from its recent fast rate”
and noted that “wages growth remains subdued and there is little upward pressure at
present”, with increased labour demand being met by more supply and public sector
pay caps suppressing wages.

“The main domestic uncertainty continues to be the outlook for consumption, with the
sustained period of only modest increases in household disposable income continuing
to weigh on consumer spending.”

Lowe said the Australian economy “has spare capacity and lower interest rates will help
make inroads into that”.

The Morrison government is reluctant to stimulate through fiscal policy, citing capacity
constraints and a desire to return to surplus.

The treasurer, Josh Frydenberg, has pointed to the government’s existing

infrastructure package and income tax cuts that will show up in next quarter’s growth
figures to justify resisting Lowe’s calls for further fiscal stimulus.

Labor seized on the rate cut, with the shadow treasurer, Jim Chalmers, arguing “if the
Liberals were doing a good job managing the economy the Reserve Bank wouldn’t have
needed to cut interest rates to another new record low today”.
“Australians are struggling, the economy is growing at its slowest pace in a decade,
wages are stagnant, and the RBA is getting no help from the Morrison government,”
he said.

But Frydenberg put the emphasis on the RBA’s reference to “the trend to lower interest
rates globally” – suggesting it had responded to global conditions rather than domestic
economic weakness.

He said it was “completely reckless of Labor to be talking down the Australian

economy” and claimed Labor had opposed income tax cuts which, in fact, they voted
for in the parliament.

Frydenberg urged lenders to pass on the rate cut, suggesting the full 0.25% was worth
$720 a year to families with a mortgage of $400,000.

The Australian Chamber of Commerce and Industry also urged lenders to pass on the
cut to give households the “greatest benefit” from lower interest rates.
On Tuesday evening, the Commonwealth Bank responded to the rate cut by
announcing it would reduce its standard variable rate for home loan customers by
between 0.13 and 0.25 per cent.

In a statement, CBA said as the RBA cash rate reached record lows it faced a “difficult
balancing act” between the multiple interests of its stakeholders.

“Particularly given it is currently not feasible to pass on the full rate reduction to more
than $160 billion of our deposits which are at, or near, zero rates,” Retail Banking
Services group executive Angus Sullivan said.

“In balancing these interests, we have carefully considered how to best meet the needs
of over 6 million savings customers – who may find it challenging to make ends meet
with record low savings interest rates – with the needs of our 1.6 million home loan
customers, who want to pay less on their mortgages; and the needs of our shareholders,
many of whom are retirees who rely on our dividend.”

The new standard variable rate for home loans will take effect on 22 October.

The Coalition has defended its goal of returning to surplus in 2019-20, suggesting that
paying down debt would give the government a “buffer” to maintain a AAA credit rating
and withstand economic shocks with future spending.

Before the third interest rate cut this year analysts including Deloitte Access
Economics had warned that successive cuts have left Australia little “wriggle room” to
revive the economy in the event of a further downturn.

The House of Representatives economics committee chair Tim Wilson has

also publicly questioned the effectiveness of monetary policy and whether interest rate
cuts are fuelling house prices, which are recovering fast in Sydney and Melbourne on
the back of looser lending rules
 ECONOMICS COMMENTARY
The article mentions recent cut of base interest rate to 0.75% in Australia. As an

economy that did not face recession for 27 years, Reserve Bank of Australia aims to

sustain a strong economic growth through monetary stimulus and thereby achieving

the two macroeconomic objectives: Stable low inflation and high employment.

Figure 1. Effect of Low Interest Rates on Aggregate Demand in Australian Economy

General Price
Level
LRAS

P1

1.6%
AD2

AD1

Real GDP
Y1 Y2 YFE
Diagram designed with Microsoft Word Office 2016

Lowering interest rate produces two outcomes for stakeholders: Decreased cost of

borrowing and decreased rate of return on savings. Therefore, households and

business sector have more incentive to spend and demand loans rather than to save.

Moreover, household indebtedness due to mortgage payments diminishes due to

decreased rate of return, thus discretionary income of stakeholders with debt

1
 increase. This leads to both an increase in consumption expenditure C, and an

increase in the investment I; and since AD = C + I + G + (X − M), an upward shift

from AD1 to AD2 occurs.

The upward shift puts inflationary pressure on the prices, and as the economy

approaches the full employment level YFE, the country’s factors of production receive

more pressure to meet aggregate demand; therefore leading to the further

exhaustion of the economy’s spare capacity. This pressure leads to an increase in

the prices – therefore costs- of production which increases the inflation from current

1.6% to P1. However, the shift from Y1 to Y2 indicates an increase in real GDP, and

therefore demonstrates economic growth, which additionally means that demand for

labor as factor of production increases, leading to higher employment rate Y2.

Figure 2. Depreciation in Australian Currency (AUD)

Australian
Dollar $ / US $

Supply

P1

P2

D1

D2
Quantity of
Q1 Australian Dollar $
Q2
Diagram designed with Microsoft Word Office 2016

2
 Furthermore, lowering interest rates causes decrease in exchange rate of Australian

currency (Figure 2). This is due to flow of hot money; which means that foreign direct

investment in Australia will shift to countries with higher interest rates and returns;

signaling decrease in demand from D1 to D2 for Australian currency, leading to

decreased value from P1 to P2. The currency depreciation produces two outcomes: On

one side, the price of imports increases, and thereby the quantity demanded and

expenditure on imports decreases. On the other side, exports become more

competitive as they are cheaper, leading to increase in total revenue from exports.

However, the article mentions “businesses scaling back” and “global trade” being

negatively affected; therefore demand for exports may not increase as expected, only

making imported costs of production higher than before.

Figure 3.Effect Of Low Interest Rate in The Long Run for Australian Economy

General Price
Level
LRAS LRAS1

P1

AD

Real GDP
Y1 YFE Y2 YFE2

Diagram designed with Microsoft Word Office 2016

3
Lowering interest rate may additionally effect LRAS. If the investment by the business

sector is directed to capital goods and R&D studies, both the quantity and the quality

of factors of production would increase. Thus, the equilibrium would shift from Y1 to Y2,

with the full employment potential shifting to YFE2, since productive and resource

allocative efficiency of the country increases.

In the short run, the effectiveness of monetary stimulus relies heavily on interest rate

elasticity. The article explicitly states that “the outlook for consumption” is uncertain,

implying that consumer and business confidence levels are not high. This means that

the policy may not lead to increase in C and I that would stimulate the economy, but

just lead to repayment of current debts which essentially has no effect on AD.

Additionally, it negates the dual effects on AD and AS in the long run, as business

investment is not directed to capital or R&D, which risks the probability of economic

overheating.

The article mentions that there is “reluctance to stimulate through fiscal policy”, which

may offset the effects of monetary policy. As this is the “third cut in five months” by the

RBA, the effectiveness of the monetary stimulus is questionable. One major issue of

interest rate is that it cannot go under 0%, and if consumers do not respond to cut as

expected, the move gives Australia very little “wriggle room”. And due to majority of

stakeholders in the household sector being households with savings, loans and

dividend pays (such as retirees and savings customers); a meagre consumer response

is expectable. Additionally, rate adjustment presents a 6-18 month time lag, which may

lead the economy to further downturn before rate is passed on to households.

4
Subsequently, the lowered interest rates may help stimulate the economy both in the

long and short run. However, the current economic outlook of decreased consumer

and producer confidence; general uncertainty in global market and the disagreement

of monetary and fiscal policies present a possibility that the rate cut will not produce

effective results. Considering double-sided effects of interest rates, the cut presents

benefit for debtors, yet negative impact on savors, therefore if the move is socially

beneficial is still questionable, and we might conclude that spare capacity of Australian

economy has reached a natural barrier.

Word Count: 750

5
References
Karp, P. (2019, October 1). The Reserve Bank cuts interest rates to historic low of
0.75% to boost weak economy. Retrieved from The Guardian:
https://www.theguardian.com/australia-news/2019/oct/01/reserve-bank-cuts-
interest-rates-to-historic-low-of-075-to-boost-flagging-economy