The Reserve Bank’s decision to cut rates shows it is fighting to maintain control over the Australian economy and is a clear move to stop Australia becoming a haven for yield investors again.
But the Reserve Bank of Australia (RBA) won’t gain full control of the Australian economy until it considers more radical moves such as quantitative easing (QE).
The RBA cut official cash rates – the first reduction in a year and a half — by 25 basis points to 2.25 per cent, pushing the cash rate to its lowest in 40 years.
Figure 1. The lowest RBA official cash rate in 40 years
Source: Reserve Bank of Australia
RBA Governor Glenn Stevens says that growth is continuing at a below-trend pace, with domestic demand growth “overall quite weak”.
But we don’t believe the RBA has cut interest rates to stimulate the economy, given that a number of ‘stabilisers’, including falling petrol prices, a rising fiscal deficit and the declining $A, are kicking in and stimulating the economy.
In cutting rates the RBA is merely responding to the global interest-rate environment. As we have pointed out a number of times, near-zero interest rates in the likes of the United States, Europe and Japan are driving investment markets with investors hungry for return and yield.
Rampant quantitative easing (QE) offshore is also creating excess liquidity in the financial system; that excess liquidity is searching for a home.
The RBA clearly wants to prevent Australia becoming attractive to those yield-hungry investors, which would cause capital inflows and upward pressure on the $A.
The cut to cash rates helps keep Australia in the middle of the yield pack; it is a preventative measure to try and keep the currency weak and keep some sort of control over the economy’s direction.
If the RBA didn’t cut, at any point in time something could trigger a flight of capital out of Europe or Japan and into Australia.
A pre-emptive QE policy
Australia should use low interest rates, but the RBA won’t gain full control of the economy until it considers and then adopts policies which acknowledge the environment created by offshore central banks.
We believe the RBA should consider a pre-emptive QE policy.
It is very hard for the RBA to think differently and utilise policies that have never previously been considered in Australia.
But there are lessons from the last six years – not least that QE is a legitimate monetary policy tool and not one that should be considered an admission of failure.
Just in the last week President Obama set the US economy for ten more years of fiscal deficits averaging 3 per cent of GDP. He did this without fear because three QE policies have flattened the US yield curve and allowed the US government to borrow substantial amounts going out for 10 to 30 years.
The same benefits from coordinated monetary and fiscal policies are available to Australia if we have the courage to set the course.
What does this mean for investors?
The RBA’s decision doesn’t change our investment thesis. Like the RBA, the global economic situation and low interest rate environment create a difficult environment for investors. The RBA’s cut makes cash and fixed income even less appealing.
But as we have been pointing out for some time, in addition to focussing on yield stocks, given that significant global risks remain, investors need to be patient and hold cash to be ready to pick up opportunities from market volatility.