The Reserve Bank's decision to keep interest rates steady at 2 per cent on Tuesday highlights the board's reluctance to cut interest rates right now, but in no way rules out further interest rate reductions in the future.
The RBA is in a holding pattern with a view to cutting rates down the track. That is the message from yesterday's policy statement by RBA governor Glenn Stevens.
The economy is doing OK, confidence is up a little in the past few months, but low inflation affords us the scope for easier monetary conditions should we need it. Unfortunately, there is every likelihood we are going to need it.
The global economy is slowing on the back of weaker emerging market growth. In Australia, the kick to growth from housing over the past few years is expected to fade in 2016. Mining and energy investment will continue to contract. We are going to struggle to grow our economy at a rate that keeps unemployment stable unless something changes.
Against this environment of modest economic growth the prospect is that inflation pressures will recede as well. Last week's lower CPI figures open the question of whether Australia's inflation rate is heading down towards the global inflation rate. Structural and cyclical factors are keeping global inflation dangerously close to zero. Wages growth around the world is being held down by globalisation and technological forces, excess capacity is evident in many industries.
The RBA has recognised the risk of weaker growth and inflation and left the door open for easing. Our expectation is that the RBA cash rate will need to come down by 50 basis points next year unless something miraculous happens in the world economy.
DISINFLATIONARY INFLUENCE
So long as global interest rates remain near zero, all the pressure on Australian interest rates will be downwards. We simply do not have enough growth on offer in our own economy to offset the disinflationary influence of the world economy.
The combination of abundant liquidity in the global financial system and Australia's higher interest rate structure means that capital is flowing into this economy. This is putting upward pressure on the Australian dollar relative to where fundamental macroeconomic factors tell us it should be. Investors in search of yield are investing in Australian dollar securities and deposits.
The result is tighter financial conditions than is warranted by the inflation and growth fundamentals of the domestic economy. For the RBA the choice is between slower growth (higher unemployment) and lower domestic interest rates and the risk of housing speculation. In reality the RBA has been navigating these conflicting forces since the GFC and have done an excellent job of it.
It is why the Reserve Bank Governor explicitly referenced the expectation that US interest rates would rise by the end of the year in yesterday's Statement. The RBA would love to see higher US rates on the back of what looks like a resilient underlying US economy. The longer US rates remain at zero, the more pressure the relatively high Australian dollar will put on the RBA to cut domestic interest rates.
Higher US interest rates and a lower Australian dollar would be a great help for the RBA. So far the Fed has not been all that obliging.
