With much thanks to the author

Craig James, Chief Economist, CommSec

Important Information

The summary and attached report has been prepared without taking account of the objectives, financial situation or needs of any particular individual. For this reason, any individual should, before acting on the information in this report, consider the appropriateness of the information, having regard to the individual’s objectives, financial situation and needs and, if necessary, seek appropriate professional advice. In the case of certain securities Commonwealth Bank of Australia is or may be the only market maker.

Interest rates: Stability reigns

Reserve Bank Board meeting

·         For the second straight month the Reserve Bank has elected to leave the cash rate at 4.50 per cent.

·         The Reserve Bank “views this setting of monetary policy as appropriate.”

What does it all mean?

·         When Reserve Bank policymakers sit down to discuss rate settings they ask one specific question – of all the possible decisions that could be made, what decision would be least regretted. Given the significant uncertainty about the outlook for the global economy, a decision to hike rates would be very risky. That is, Board members could very well regret the decision. And while indicators of the domestic economy have become quite mixed, the Reserve Bank is giving no hints that rates should be cut. Again it would be a decision that would be likely regretted in the future. So the safest course of action is to do nothing.

·         There is certainly no urgency to move rates in either direction – up or down. While some analysts are worried that domestic inflation may prove higher than normal in coming months, it is important to consider what factors are driving it. If inflation is being driven by higher council rates or utility charges, then a cash rate increase won’t help the situation. The Reserve Bank believes that underlying inflation will remain below 3 per cent over the next year. Provided there is no change to this forecast after the next inflation data on July 28 then the Reserve Bank has no justification to move rates in any direction.

·         The Reserve Bank is as relaxed and comfortable as it is ever going to get. The Bank says that the global economy is growing at trend pace; that Australian economic growth is likely to grow around trend over the coming year; that inflation is likely to remain in its target band; and that interest rates are back at normal. The bottom line being that all is right with the world.

·         While CommSec believes that it is more likely that rates will rise rather than fall in the future, the next move could very well be in 2011 if the mixed domestic and global economic readings persist. The rate hiking cycle from 2002-2008 was characterised by long periods of interest rate stability between short periods of rapid-fire rate increases.

·         Certinly the changing interest rate environment of the last few months as provided borrowers with a lot of choice. A borrower may elect to stick with a variable rate loan, while other risk-averse borrowers may elect to fix borrowings for either two or three years without any major penalty in the rate differential.

Interest rate decision and past cycles

·         The Reserve Bank Board has left the cash rate at 4.50 per cent for the second straight month. In October 2009 the cash rate stood at a 49-year low of 3.00 per cent. But then the RBA embarked on a process to remove the emergency stimulus, lifting the cash rate by a quarter of a percent in October, November and December 2009, and then in March, April and May 2010.

·         In the last rate-cutting cycle the cash rate fell to a low of 4.25 percent in December 2001. In the two previous rate-cutting cycles, the cash rate fell to lows of 4.75 per cent.

·         In response to funding pressures, banks have been forced to lift rates above the cash rate over the last 10 months. As a result, the Reserve Bank has looked more closely at the variable housing rate to gauge how close rates are to “normal”. Currently the average bank variable housing rate stands at 7.40 per cent, above the long-term average or “normal” rate of 7.15 per cent.

·         The Reserve Bank says: “The current setting of monetary policy is resulting in interest rates to borrowers around their average levels of the past decade. Pending further information about international and local conditions for demand and prices, the Board views this setting of monetary policy as appropriate.”

What are the implications of today’s decision?

·         Borrowers have plenty of choice. Anyone wanting to fix some, or all, of their loan, can do so with no penalty in terms of higher interest rates. For those worried about future rate hikes, the current interest rate settings are very favourable.

·         Over the past week more concerns have been raised about housing affordability. But most of the reports on housing affordability aren’t worth the paper they are printed on. The Rismark affordability index that covers all Australian home prices and all Australian income is the best measure of housing affordability and it shows that it is basically going sideways. Those are the facts, a point acknowledged by the Reserve Bank. So home prices have no impact on Reserve Bank rate decisions. The issue in the housing market is on boosting supply, rather than choking off demand.

·         Banks will continue to compete hard for available deposit business. So savers remain in the ascendancy. Banks are generally offering around 6 per cent for a $10,000 term deposit at a time when market rates are below 5 per cent and returns on shares are decidedly soggy.

Comparing the two most recent statements

·         The statement from the June meeting is on the right; the statement from today’s July 2010 meeting is on the left. Emphasis has been added to significant changes in wording in the recent statement.