Too eager for an interest rate cut?

July 20th, 2008

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Ever since the governor of the Reserve Bank of Australia (RBA) made the speech last week, the mainstream media has been catching on to the idea that interest rates in Australia is at the peak and the next move will be a cut. For example, The Age came up with a highly misleading and sensationalising headline: RBA chief throws borrowers a bone. We are sure that such headlines will give some property ‘investors’ (read: speculators) the wrong idea that the property bubble will re-inflate when such a day arrives.

First, let us understand the context of what Glenn Stevens said. In Australia, our central bank has a policy of targeting inflation within a band of 2% to 3%. Note: If you want to know the long story about how inflation targeting come about as a policy, take a read at our earlier article, Why should central banks be independent from the government? which contains a link to the RBA’s web site. There are some who fear that with the credit crisis and rampaging oil prices, any rigid and inflexible adherence to the inflation target band through monetary policy will result in a serious crisis for Australia. In other words, the belief is that the RBA should be flexible enough to let inflation veer off the course. We believe it is in this context that Glenn Stevens reportedly said that he will not “wait until inflation has retreated below 3 % before cutting interest rates.”

Second, though it may be true that the next interest rate move in Australia will be down, it may not be imminent. In fact, it may be quite a while before it happens. So, those who are waiting for an interest rate cut to do wonders to their asset speculation should not be too hopeful yet.

Third, should interest rates be cut sooner than expected, it will probably happen in the context of a credit deflation, which is hardly good for asset prices. In other words, you will not want to see the day when the RBA is forced to cut interest rates desperately because it will be a day when the economy is slowing too dangerously. As we said before in Can lower interest rates re-inflate the property price bubble?,

But what if the economy slows down too much for the RBA?s liking? In that case, given the high levels of debt of Australians, if the economy slows down too much, the Australian economy can tip into a dangerous downward deflationary spiral.

Fourth, an interest rate cut by the RBA need not necessary mean a cut in the mortgage rate. In fact, the opposite can occur. How? Why? We will discuss more about this in our next article. Keep in tune!

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