It was just a few months ago, the Reserve Bank of Australia (RBA) was very hawkish on interest rates. Its priority was to fight price inflation and with that, even approved of the banks raising their mortgage rates. It was said that if not for the mortgage rate rises, the RBA would have raised rates even more.
It seems that all of a sudden, the RBA began to hint strongly about cutting interest rates. What is going on? As this article, The Great Interest Rate Forecast Back Flip, reported,
Indeed, the Macquarie analysts are actually concerned the sudden turnaround in RBA intention suggests it might know something about the economy we don’t. “Has the RBA’s business liaison program revealed some financial fragility in the economy that has not yet been unveiled?” while suggesting that “for this reason lower interest rates are unlikely to be the green light for growth investors might hope for”.
One thing many experts even fail to understand is that a fall in interest rates does not automatically mean a loosening monetary policy. As we explained before in What makes monetary policy ?loose? or ?tight??,
A common misperception is to assume that any rise in interest rates automatically implies a monetary tightening (and conversely for a fall in interest rates).
What had been happening is that the demand for credit in the Australian economy is decelerating very rapidly. That is, Australian households, individuals and businesses scaling back on their borrowings. When the demand for credit slows down tremendously, what was before a ‘loose’ monetary policy can become ‘tight’ all of a sudden. If credit demand falls further, the RBA can still cut interest rates and still have ‘tight’ money. If you are confused by this, please read our earlier article, What makes monetary policy ?loose? or ?tight??.
The best way to explain this concept is to use Japan as an example. In the 1990s, Japan famously cut interest rates to zero. Yet, asset prices kept on falling for 16 years straight. That is an excellent example of deflation whereby credit became a dirty word. Even when interest rates was zero, Japan’s monetary policy was still ‘tight.’
For Australia, a rapidly decelerating credit growth is very bad news. Since a lot of Australian consumer spending is financed by the growth of credit, this will mean a severe slowdown in the Australian economy. Furthermore, rising asset prices is fuelled by exponential increase in credit. A rapid deceleration of credit growth will result in asset price deflation.
We can imagine the RBA worrying about the storm clouds gathering ahead- US is in recession, UK is going to fall into recession, Europe is stumbling into recession, Japan is feared to fall into recession, falling commodity prices, China is slowing down, etc. If the rest of the world economy is slowing down significantly, there is no way Australia can escape.
Tags: asset prices, consumer spending, credit, interest rates, monetary policy, RBA, recession
