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The RBA and the Goldilocks theory of interest rates

Not too high and not too low. Leaving the interest rate at 3% seems to be ‘just right’ as far as the Reserve Bank is concerned today.

Interest rate cuts are a bit like an anaesthetic where it takes a little time to have an effect and there’s always a period of time before it wears off.

And so it is with the RBA’s position having cut rates a couple of times late last year, the Board is sifting the economic data to see how much effect it has had.

House prices in Australia’s capital cities were up 1.6% in the December quarter according to the Australian Bureau of Statistics.

Inflation has remained within the target band of 2-3%.

Unemployment has stayed relatively benign at 5.4%.

Internationally, the RBA is wary of Europe’s geriatric malaise and cautious about the US economic recovery and isn’t quite sure what to make of Asia’s adolescent growing pains.

The decision not to act in February of course does not signal the end of the easing phase. Rather, it suggests the RBA wants to optimise the effect of cutting interest rates by spreading them out.

Consumers are the real target of the Board’s tweaking. Chop rates too quickly or too much and inflation will zoom up creating problems for everyone. Take the opposite tack and deflation can cause as much damage. Getting the balance just right is therefore a sensitive task not borne lightly by the guardians of our monetary system.

For a large chunk of Australia’s ambitious home-owners, opening the door for retail banks to lower mortgage rates is what the RBA is there to do, but for the nation’s savers, interest rate cuts might mean a few less goodies in the shopping basket each week.

Having begun the easing cycle last year and with rates now at levels at which the RBA describes as very low, the impact of further rate cuts is possibly diminished. Also dragging against the RBA’s stimulus is the fiscal policy of the government which appears loathe to put its own shoulder to the stimulus wheel.

It’s important to remember that Australia’s interest rates remain high relative to most other developed nations and this is the primary cause of the strength of the Australian dollar. Many export-oriented businesses would love to see a lower dollar, but the price of imported goods has probably never been cheaper thanks to the same factor.

The level of indebtedness on Australia’s corporate balance sheets has probably never been more conservative, so lower interest rates aren’t necessarily a good thing either. Perhaps corporates need to be brave and take the plunge while rates are low, and invest in more capacity (people and plant) before the real upswing kicks in. The retail banks would clearly benefit from a lift in credit growth too.

The bottom line is that interest rates in Australia are historically low. In isolation, this is not a catalyst for economic growth but it is definitely a prerequisite.

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