Interest rates: why a further cut is not a good idea

Nov 2, 2020

Interest rates are already at record lows. Any further cut will not help the economy but will add to the inequality of wealth in this country.

Credit – Unsplash

The economic pundits in the media and the financial sector are unanimous that the Reserve Bank (RBA) will cut interest rates next Tuesday, lowering the cash rate from its present rate of 0.25% to a minuscule 0.1%.

It says something about the reverence with which the high priests of the RBA are held in this country that no one is questioning whether or not this expected cut in interest rates is a good idea. Furthermore, since the RBA lowered the cash rate to 0.25% in March this year, the Governor has made clear his opposition to negative interest rates and he implied that a cash rate of 0.25% was as low as it could get, stating that “it is highly likely that the cash rate will be at this level for some years”.

The reality is that if the cash rate is further lowered by a tiny 0.15% that will make no difference to spending, which is what matters right now.

Assuming this cut in the official cash rate is fully passed on by the banks, past experience tells us that such a small reduction in the cost of borrowing will not materially increase the willingness of households or business to borrow and thus spend more. Instead most existing borrowers – and they are the vast majority of borrowers – will continue to repay these existing loans at their old rate each month. These borrowers will therefore experience no increase in their spending power, but instead will be paying down their debt slightly faster and thus saving more.

Furthermore, what we have discovered from the experience of past interest rate cuts is that their main immediate impact has been to increase the price of assets, particularly share values and real estate prices. Of course, the assumption is that as share values increase, the owners are thereby encouraged to increase business investment. And that can happen, but typically only after demand has also increased, as there is no point in expanding the capacity of a firm’s equipment if it cannot sell all the product from its existing equipment.

In the case of first-home buyers, the increase in house prices in response to the interest rate cut, actually makes it more difficult for them to enter the housing market. Consequently, this interest rate cut risks reducing the demand by first-home buyers and thus the demand for additional homes.

To sum up, a further small reduction in official interest rates is unlikely to help restore aggregate demand and employment. Instead, its main impact will be to increase asset prices, which will in turn lead to a further worsening of the inequality of wealth distribution in this country.

One wonders why in these circumstances the Reserve Bank is reported to be now contemplating another interest rate cut.

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