What are the implications of falling interest rates?
21.09.08
For the first time since December 2001, the Reserve Bank of Australia (RBA) has cut interest rates, taking the official cash rate here in Australia from 7.25% to 7.00%. It seems that the recent run of economic data and anecdotal evidence suggests that the significant slowdown in domestic demand the RBA was looking for is underway.
It is also widely accepted that the RBA has clearly ‘left the door open’ for more rate cuts and it is likely interest rates will fall further as sub-par growth adds to confidence that inflation will fall.
Implications for The Australian Economy
Rate cuts are good news for the economy.
After 12 consecutive official interest rate increases since May 2002, additional increases of 0.5% to 0.6% in bank lending rates on the back of the credit crunch, 30% slump in the share market, falling house prices, surging petrol prices and a near-parity Australian dollar (…phew!), the risks of recession in the economy were significantly increased. The result of all this has been an abrupt downturn in the economy, evident in a slump in consumer and business confidence, falling retail sales volumes, a slump in housing related indicators, a sharp slowing in credit growth and a softening job market. Fortunately, the RBA has seen the evidence and done an ‘about face’.
However, there are several things to note.
- Apart from an initial confidence boost, one rate cut on its own will not have a big impact. For a family with a $250,000 mortgage, a 0.25% interest rate cut amounts to a weekly saving of only $12.
- The lag from rate cuts is long and variable, usually around 12 months. Given the massive tightening in financial conditions over the last year is still working its way through the economy, some economists feel it is likely that we will see a further deterioration in economic growth over the next 6 to 12 months.
- The worsening slump in the global economy suggests further downward pressure on commodity prices, which may start to soften the mining boom in the short term. Although the longer-term outlook remains strong, there are also signs that growth is starting to slow in China.
- Without a cut in bank lending rates, RBA rate cuts are purely academic. Though it is good to see the major banks immediately cutting their mortgage rates in response to the rate cut from the RBA, it is unclear how they will respond to subsequent cuts. However, confidence can be found in the fact that bank funding costs have been falling, and the RBA can just keep cutting the cash rate if necessary until it gets the mortgage rate it feels is appropriate.
Implications for Housing
The move to lower interest rates coming into the spring home-buying season may see the housing market perk up a bit in the next month or so.
However, it is likely to be temporary (housing likely to remain weak for the next 12 months) as a range of factors point to continued tough conditions:-
- Housing affordability remains terrible and it will take several mortgage rate cuts and a decent decline in house prices to produce any significant improvement.
- Australian house prices remain overvalued relative to rents and average household income levels.
- The downturn in the economy is likely to result in rising unemployment over the year ahead, offsetting the impact of interest rate cuts and keeping buyers on the sidelines for a while in an environment of restrained mortgage credit availability.
Implications for Australian Shares
Falling interest rates are normally good for shares because they help future profit growth and make shares more attractive compared to cash. Shares have already fallen sharply and look very cheap and strong resource sector profits are likely to underpin overall profit levels. However, news flow is likely to remain poor over the next few months with more earnings downgrades, more bank provisioning for bad debts and more bad global news.
Bearing this in mind, with interest rates falling there is reason to be more confident about the 12 month outlook for Australian Shares.
