The Reserve Bank of Australia cut the official cash rate by 25 basis points to 1.75% in May, making this the first cash rate cut since May 2015.
The decision was a tough call amid lower than expected inflation, low consumer sentiment and a downward trend in house price growth.
The cut had a powerful effect on the Aussie dollar (AUD), which lost over 2% against the US dollar (USD) in a single trading day.
By close of trade, the AUD was at US$0.75.
Graph 1 shows what happened to the AUD when the RBA announced the cash rate cut.
So why did the AUD take such a strong hit in reaction to the cash rate cut?
When official interest rates on Australian dollars are lowered, the currency becomes less expensive to borrow – it is devalued.
This may have led traders to sell off the AUD, as the currency they were holding was about to be worth less.
When the RBA has previously cut rates, traders expected prices to go down but back up again in the long run.
This means that previous rate cuts have been followed by a small rally in the AUD, as people think the AUD is a bargain fresh after rate cut announcements.
However, the AUD has not rallied this time, suggesting people expect the AUD to stay low or keep going down.
The RBA has been hoping for a drop in the AUD to make Australian exports more competitive.
Unfortunately, if you planning a holiday the United States, this might not be good news:
With the AU$1.00 buying just US$0.75, Australians are losing purchasing power for US goods and services.
Until inflation was reported on 27 April, few people expected a cash rate cut this month.
Inflation – the rate at which the price of goods and services increases – was just 1.3% in the year to March, which is well below expectations of 1.7%.
The monthly inflation result showed that prices actually declined across the country by 0.2%.
When inflation is low or falling (falling inflation is also known as deflation), central banks tend to lower interest rates to encourage borrowing and spending, thus pushing up inflation.
Central banks have an ‘inflation target’ where interest rates are used to keep inflation between 2 to 3% per year.
Market expectations of a cash rate cut were indicated by the AUD before the announcement, which instantly dropped in response to the news of low inflation, as shown in Graph 1.
This is because investors may have assumed that the low inflation would prompt the RBA to drop rates and started to pre-emptively sell off the AUD.
Graph 1: Movements of the AUD in Response to Inflation Report
However, the power of an interest rate cut to actually stimulate inflation may be limited.
This is evident from Japan and the Euro area, where central banks are struggling with deflation despite negative interest rates.
Lower interest rates in these regions have led to a loss of confidence in the economy, which has perversely worked to further limit spending and drag down inflation.
This monetary tool seems less effective than it has been in the past to stimulate spending, and a lower cash rate potentially threatens confidence in the Australian economy.
In Australia, the March inflation figures suggest that consumption is falling in the economy.
This is unsurprising given that 2015 saw a rapid increase in the cost of housing while wage growth was at a historically low 2.2%.
As housing costs rose over 2015, people likely had to reallocate their largely stagnant incomes which would have led to a larger portion of income servicing housing costs and less going to things like food and entertainment.
However, as of March this year, the major east coast markets are coming into a downswing phase with the price of houses and units in Sydney and Melbourne beginning to fall.
Our latest data shows that the median house value in Sydney fell by 2.17% in the March quarter, which is equivalent to around $23,000.
In Melbourne, during the same period, the decline was $11,000 (-1.53%).
This is an expected part of property growth cycles.
In fact, of the eight capital city markets, six saw a reduction in house values for the March quarter.
Graph 2 displays monthly capital for the median house across Australia.
Graph 2: Australian Houses Growth Cycle – Capital growth rates come into a downswing
As demonstrated in the graph, this market peaked in late 2015 and is now moving into the downswing phase.
As Australians are usually very responsive to interest rate cuts and the demand for housing, holding the cash rate steady at 2% may have allowed quicker adjustment to more affordable dwelling prices.
However, holding the cash rate in the context of falling house prices can also be dangerous for consumption.
This is because in Australia, houses contribute to the ‘wealth effect’.
When the value of houses begin to fall, people believe they have less purchasing power and spend less.
When this is the sentiment, easier access to credit may be beneficial, justifying a cut in the cash rate.
The Westpac-Melbourne Institute of Consumer Sentiment Index fell by 4% in April to 95.1.
The index, compiled from a survey of 1,200 households, suggests that people were generally more pessimistic about the economy in April than optimistic.
Unemployment at March was 5.7%, but the labour force participation rate has also trended down to 64.9%.
It is worth noting that the participation rate is still above the 20 year average of 64.2%.
The cut in the official cash rate may expand employment opportunities.
A bright spot in the economy came from the Ai Group’s performance of manufacturing index (PMI), which was at 53.4 in April.
Although this is well below the previous month, an indicator of above 50 signals growth.
The Manufacturing PMI has been trending upwards since July last year.
This month’s rate decision came on the same day as the Turnbull government hands down the Federal Budget.
At its meeting in April, leaders of the International Monetary Fund encouraged both fiscal and monetary leaders to cooperate in easing access to capital and promoting greater equity in the distribution of wealth.
A reduced cash rate will give the government slightly more flexibility in implementing fiscal policy, which seems to be directed at stimulating growth for business.
Given falling output, demand from China and persistently low commodity prices, the cash rate cut may also make Australia more resilient in the face of future economic shocks.