Does monetary policy still work?

Pushing on a string?

Some interesting debate on social media this week about whether lower interest rates still ‘work’ in terms of stimulating inflation and the economy.

Business Charts And Graphs On Screen With Interest Rates TitleSo the argument goes, there’s little point in cutting rates because, well, people will just pay down more debt and there will be no benefit to the real economy.

I don’t believe that.

For starters Aussies still have some $404,227,000,000 in interest-only mortgages for which the borrowers would very much enjoy lower interest rates, while there would be a confidence boost for owner-occupier households, and probably a boost for new housing investment too (in fact, the housing downturn would almost certainly be over).

But even if the contention was true – and I don’t believe it is – mortgages and the housing cashflow channel is only one of the ways in which monetary policy is effective.

And here are the others courtesy of the Reserve Bank itself:


Source: RBA

Lower interest rates boost asset prices, change inflation expectations, and encourage less saving and more spending.

Households have hoarded an unprecedented war chest totalling well over $1 trillion of cash and deposits through this cycle, some of which can be prised out.

Lower rates also reduce the cost of business funding and, at the margin, encourage business investment decisions.

By rights we shouldn’t even be having this conversation when the cash rate is still well above the zero lower bound.

With inflation tracking close to record lows the real cash rate is no longer negative, so something is too tight, be it monetary policy or the supply of credit.


Exchange rate channel

An often overlooked mechanism is the lower dollar that would result from rate cuts or unconventional measures such as quantitative easing.

Let’s look at one very simple example for Australia.

Before the resources boom we’d always had many more people visiting these shores than there were Aussies jetting off to spend their hard-earned dollars in Bali or Tokyo.

But as the dollar soared and Australians built up unprecedented household wealth towards $10 trillion and beyond, off we went to explore the world…and fair enough too.


This trends is gradually turning around with the dollar at 70 US cents.

Exchange RateBut if you push the dollar down towards the 50-60 cent range or lower suddenly we’d be holidaying and spending at home again, and tourists would be lining up to come here and spend too.

More broadly the exchange rate is one of the simplest and most effective channels for monetary policy…and it still works.

A lower dollar for Australia also boost foreign investment and our export income.

Whatever it takes

As for recent evidence of monetary policy working over time, check out unemployment rates in the US where the unemployment rate has fallen as low as 3.8 per cent.


Or closer to home (for me anyway), look at Britain, where the unemployment rate has fallen to a 44-year low at under 4 per cent, and wages are now rising at 3½ per cent.

A2 (1)

Some commentators have argued that central banks have become unconsciously biased towards tighter policy and building monetary firepower so as to maintain their relevance.

Others have suggested that Australia’s central bankers may even be fêted at global conferences, or lauded for never having been driven to the zero lower bound or quantitative easing through the financial crisis, and as such as reluctant to go lower.

I wouldn’t know about any of that, but although it takes commitment and credibility the answer to whether lower rates still work must surely be an emphatic ‘yes’.


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Pete Wargent


Pete is a Chartered Accountant, Chartered Secretary and has a Financial Planning Diploma. Using a long term approach to building businesses, investing in equities, & owning a portfolio he achieved financial independence at the age of 33. Visit his blog

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