Policy debate hinges around risks of ultra low interest rates: Bill Evans

EXPERT OBSERVER

The employment report for September printed a modest fall in the unemployment rate from 5.26% to 5.20%. Further, the underemployment rate fell from 8.53% to 8.35%.

That will be sufficient to avert another rate cut from the RBA in November.

Westpac has consistently argued that a cut in November was unlikely and the Employment Report strengthened our case.

The October RBA meeting minutes made an important point that had not been part of earlier commentaries:

“Members also discussed the possibility that policy stimulus might be less effective than past experience suggests. They recognised that some transmission channels, such as a pick-up in borrowing or the effect on the home-building sector, may not be operating in the same way as in the past, and that the negative effect of low interest rates on the income and confidence of savers might be more significant. Notwithstanding this, transmission through the exchange rate channel was still considered likely to work effectively, and evidence suggested that the positive effects of lower interest rates on aggregate household cash flows via lower debt repayments was likely to support household spending, given that household interest payments exceed receipts by more than two to one”.

This point is highly relevant for any discussion around the Effective Lower Bound (ELB) for the cash rate in this cycle.

Certainly, with the Board targeting full employment (currently assessed by the RBA as 4.5% compared to the actual of 5.2%)and a move into the 2–3% target zone for underlying inflation, it seems certain that the RBA will reach its ELB before it achieves its objectives.

Westpac’s current forecast (first set out on July 24) is that the ELB is 0.5% and will be reached at the February Board meeting.

However this process is different to the normal process for forecasting the end point of any policy cycle. That forecast typically hinges around forecasting how far below (or above) neutral (or R*) the cash rate will need to be pushed before the authorities can be comfortable of achieving the objectives of full employment and inflation sustainably in the 2–3% target range.

So the policy around choosing the ELB will likely be determined by the trade-off between the expected impact of further cuts and unanticipated consequences of ultra-low interest rates.

The minutes have already highlighted one risk – the impact of ultra-low rates on confidence. That effect was further emphasised by the 5.5% fall in the Westpac-MI Consumer Sentiment Index in October to its lowest level for four years. The survey was conducted during the week of the announcement of the 0.25% cut in the cash rate from 1% to 0.75%.

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BILL EVANS is the Chief Economist at Westpac