How low will official interest rates go? (and what comes next?)
Tuesday 18 February 2020
After 30 months of inactivity, the RBA decided to cut the cash rate three times last year, and is poised to pull the trigger again in 2020. But just how low will official interest rates go?
Back in 2012, the cash rate was 4.25%, and the average savings account would have given you around 3.94% p.a. in interest. That’s a far cry from today’s rates. Right now, the cash rate sits at 0.75%, and the average savings rate is a paltry 0.97% p.a.
Will interest rates in Australia dip below zero?
While official interest rates are hovering perilously close to zero at the moment, it’s very unlikely they’ll reach that point, let alone drop further.
Australia’s central bankers have flagged 0.25% as the effective lower bound, meaning they have 0.50% left to cut before they resort to other measures.
What’s more, RBA Governor Philip Lowe has shown a clear bias against negative interest rates. At an economists meeting late last year, he explained that while several countries have let interest rates drop below zero, he’s not particularly convinced it’s done anything to help them.
“It has become increasingly apparent that negative rates create strains in parts of the banking system that can impair the ability of some banks to provide credit,” he said.
“In addition, there is evidence that they can encourage households to save more and spend less, especially when people are concerned about the possibility of lower income in retirement.”
That last point is important. One thing the RBA must be painfully aware of at the moment is that there’s a fine line between encouraging spending and fueling precautionary saving, and if the economy is to recover we need to start seeing less of the latter.
It’s also generally understood that the effectiveness of monetary policy diminishes the closer official interest rates get to zero, as banks double down to ensure the margins between home loan and deposit rates stay profitable.
What is quantitative easing?
So if 0.25% is the effective lower bound, what will the RBA rely on to stimulate the economy once things reach that point? One major tool it has at its disposal is quantitative easing (QE).
This is a pretty difficult concept to get your head around, so bear with us. In its most basic form, QE is when a country’s central bank purchases bonds with the intention of reducing long-term interest rates.
As the RBA buys more bonds, it drives up their market price, which then pushes their interest rates down. The thinking goes that the additional liquidity from lower bond rates will flow through to the economy, fuelling investment, lifting asset prices, and lowering the exchange rate.
Going down the QE path would be uncharted territory for Australia, but the unorthodox policy has already been implemented abroad.
Its first testing ground was in Japan back in 2001. With deflation spiralling out of control, the Bank of Japan began purchasing trillions of yen worth of government bonds each month using money it created electronically.
During the financial crisis of 2008, the US Federal Reserve also resorted to QE to salvage a crumbling economy. It embarked on a bond-buying program of US$85 billion a month (later scaled back to US$15 billion a month).
What will this mean for Australians?
If successfully implemented in Australia, QE could flush the country with money and put a floor to our current economic woes.
But how exactly will it benefit mortgage holders? Simply put, QE would make it easier for banks to keep interest rates low. Ideally, this would give Aussie budgets a bit more breathing room and go some way towards ending the current spending strike.
Until then, it’s a good idea for anyone with a mortgage to shop around and make sure they’re not paying more than they need to be. If you think refinancing would improve your financial situation, visit our home loan comparison page for a look at what’s currently available.