Would the RBA’s rate cut do any good?

August 6th, 2008

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On Tuesday, the Reserve Bank of Australia (RBA) hinted that the case for an interest rate cut has increased. As this announcement from the RBA said,

Weighing up the available domestic and international information, the Board judged that the cash rate should remain unchanged this month. Nonetheless, with demand slowing, the Board?s view is that scope to move towards a less restrictive stance of monetary policy in the period ahead is increasing.

The last sentence gave the financial markets the excuse to punt on interest rates cuts later in the year. No doubt, many would be eagerly waiting for this day to come. They thought, perhaps, rate cuts would help bring in a new boom in asset prices?

The RBA may cut interest rates, but the price of credit may not follow. You see, when the RBA cuts interest rates, they are merely setting the target of the cash-rate, which is the rate of overnight loans between banks. The cash-rate is only one of the many short-term interest rates. As we explained in How does a central bank ?set? interest rates?,

… there are many kinds of interest rates, which can be categorized into either short-term interest rates and long-term interest rates. An example of a long-term interest rates include the 10-year Commonwealth Treasury bond yield.

The cash-rate will then have an influence on the other interest rates in the economy (e.g. bank bills). Unfortunately, thanks to the credit crisis, this influence had waned. The fact that mortgage rate is moving independently from the cash-rate is testament to that fact.

Then, there is another possible danger. As this article,  Debt mutes the horn of plenty, noted,

Bank deposits have not been enough to fund the rise in household borrowing, so the banks have turned to world markets, which have been more than willing to lend. They are still willing, albeit at a much higher interest rate than was being charged a year ago.

“The funding costs can only get worse if we see interest rates come down here and the currency starts to fall, so that the attractiveness of lending to Australia diminishes,” Minack says.

If the Australian dollar falls as a result of interest rate cuts by the RBA, there are two possible adverse results for Australia:

  1. Foreign lending to Australian households may be reduced, which means the cost of credit will go up, as we explained in Can falling interest rates and rising mortgage rate come together?.
  2. The rise of the Australian dollar has shielded Australian households from the worst of the commodity price inflation, most notably oil. A fall in the Australian dollar will imply a rise in the price of these commodities. This will not bode well for the Australian price inflation rate.

As we explained before in Is the credit crisis the end of the beginning?, the de-leveraging process in the global financial system still has to yet to run its full course. Consequently, the price of credit will continue to rise, regardless of central bank’s rate cuts. The rising price of credit and further credit tightening will lead to further deceleration in credit growth, which in turn will be very detrimental to asset prices and the real economy.

We will not taking RBA’s rate cut as ‘good’ news.

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