Interest rate cuts have been delivered by the RBA, and more are needed, because lower interest rates encourage households and businesses to borrow and invest and discourage households and businesses from saving.
This is the most basic principle of monetary economics.
The RBA now knows that GDP growth has been mired for 3½ years below trend (estimated to be 3.0%) and has averaged just 2.0% per annum over that time. It knows that because of this sub-optimal performance, employment growth is weak and jobs are now being lost. It knows that fiscal policy is contractionary. It is about to find out how inflation ended 2011 (the December quarter CPI will be released next week) with there being not much doubt that inflation will be comfortably within target.
The RBA also knows that Australia needs a little more spending and investing and a little less household and corporate saving if growth is to move back to an even keel, if jobs growth is to return and if inflation is to be maintained with its target range. The government sector is certainly not providing that impetus as the budget returns to surplus, so the RBA must weave its magic to underpin growth and employment in a low inflationary climate.
If consumers choose lower interest rates to pay off their mortgage faster, (they keep their repayments at a higher level), this is part of the mechanism of monetary policy working. It’s deleveraging at least in the short term. What’s more, at a time when house prices are falling, this approach would see the net equity position of mortgage holders being held up (and not falling - the disaster scenario) which means banks are unlikely to suffer from too many mortgage holders with low or negative equity. It helps the banks as well as making mortgage holders more comfortable financially. In time (this is the long and variable lag in monetary policy), hopefully these currently frugal mortgage holders will be so comfortable with their financial position that they will lift their spending and investment again.
Is the alternative to hold interest rates at current levels which adds to risks of negative equity in houses, keeps mortgage cash flows on the border line and adds to economic uncertainty? I think not!
And if savings interest rates are crimped with official interest rate cuts, the incentive to save via bank deposits is lowered. Why put money in the bank if you get a low return? I might as well do something different with my money. The incentive to spend is therefore a bit more is enhanced, and there is a greater incentive to look for alternative (ie higher returning) investments. This may be in the form of householders providing capital via stock market investment, residential property investment (good for housing supply) or through higher yielding corporate bonds. It helps the economy.
Any talk that lower rates will mean a cut in incomes from savers is most confusing and impossible to understand.
As a counterfactual, should the RBA hike rates a few percentage points to boost savings incomes and therefore growth and job creation as deposit holders spend this extra money? Absurd.
It’s niave to say that interest rate cuts wont work. They will! It’s just the speed and extent to which they work - which is why the RBA meets so frequently to consider monetary policy. It can jiggle rates one month, tweak them the next, go into emergency mode the next should conditions demand such action. It can hike, cut or keep them steady with each decision aimed, in broad terms and over the longer run, at keeping GDP growth averaging 3%, inflation 2.5% and employment growth sufficiently robust to hold the unemployment rate at a low level.
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